This week's big swings in the U.S. market: hedge funds "short everything," software stocks started seeing buying on Thursday, and a "brutal short squeeze" on Friday

This week, the U.S. market experienced rare and intense cross-asset class volatility, driven by unprecedented large-scale short selling by hedge funds, which then evolved into a brutal short squeeze on Friday.

According to Goldman Sachs prime broker data, hedge funds’ single-day short sales of U.S. stocks reached the highest level since records began in 2016, with a short-to-long ratio of 2.5 to 1. This wave of short selling not only swept through the stock market but also affected precious metals and cryptocurrencies, leading to the biggest declines in gold and silver in decades, and Bitcoin experiencing its largest single-day drop since November 2022.

Market sentiment shifted on Thursday. Goldman Sachs observed that institutional investors began buying into IGV (the Software Sector ETF), which saw a 12% increase in shares on Wednesday, the largest single-day increase in 2023. This signal suggests that the selling may have bottomed out.

On Friday, the market immediately saw a short squeeze, with Goldman Sachs’ most shorted stock basket soaring 8.8% in a single day, the second-largest increase since 2022. However, Goldman Sachs’s analysis indicates that Friday’s short covering only absorbed about 20% of the short positions, implying that further short squeeze momentum could continue.

Unprecedented Short Selling Scale

Goldman Sachs prime broker data shows that hedge funds have been net sellers of U.S. stocks for four consecutive weeks, with short sales far exceeding purchases.

Single stocks became the main casualties of short selling. Goldman Sachs records show that this week, the nominal short selling of individual U.S. stocks reached the highest level since 2016, exceeding the five-year average by 3.2 standard deviations, with a short-to-long ratio of 2 to 1. Macro products like indices and ETFs also experienced net selling, accounting for 30% of total net sales, driven entirely by short selling.

Of the 11 industry sectors, 8 experienced net outflows, with the largest in dollar terms in Information Technology, Consumer Discretionary, Consumer Staples, Industrials, and Real Estate. Healthcare, Communication Services, and Utilities were the only sectors to see net inflows.

Software Sector Becomes Short Selling Focus

The Information Technology sector was the worst performer and the most heavily shorted, with short sales in the past five years second only to this week, exceeding the five-year average by 3.2 standard deviations, with a short-to-long ratio of 5.4 to 1.

The software industry was the hardest hit within the tech sector, accounting for 75% of the net dollar sales in Information Technology, followed by Communication Equipment and Technology Hardware. In contrast, semiconductors and semiconductor equipment, as well as IT services, saw the most net buying. Goldman Sachs data shows that the total net exposure (as a percentage of total U.S. market cap) and the long-short ratio in the software industry are currently at 2.6% and 1.3, respectively, both hitting all-time lows.

JPMorgan’s holdings intelligence team noted that the recent stock declines and factor volatility have dragged down hedge fund returns, with all strategies globally averaging a 1.8% decline this month, including a 2.0% drop in equity long-short strategies, and declines of 2% to 2.5% in multi-strategy funds. Quantitative strategies declined by 1% on a market-neutral basis.

Key Buying Signal Emerges on Thursday

The market sentiment shift occurred on Thursday. Goldman Sachs ETF trading team observed that institutional investors began buying IGV on Wednesday and Thursday.

The fund’s shares increased by 12% on Wednesday, marking the largest single-day change in 2023. Goldman traders believe this “feels like direct buyers trying to find a bottom and participants possibly at a climax of short covering.”

Despite JPMorgan’s holdings team remaining cautious, noting hedge fund leverage remains high and that the de-leveraging in North American markets over the past few weeks was only -1.1 standard deviations, Goldman Sachs’s trading team explicitly stated on Thursday that the software sector has bottomed.

Short Covering Explosion on Friday

On Friday, the market confirmed Goldman Sachs’s judgment, with software stocks rebounding sharply, and high-beta assets like momentum stocks, Bitcoin, and silver surging across the board.

Goldman Sachs’s most shorted stock basket soared 8.8% on Friday, the second-largest single-day increase since 2022. This short squeeze affected the most battered sectors.

However, Goldman Sachs warned that Friday’s short covering only absorbed about 20% of the recent short positions backlog. This suggests that unless short sellers double down on their bearish positions, a larger rebound could occur on Monday, not only in the most fallen parts of the market but potentially spreading to other areas.

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