Summary

• The 2023 stock market resurgence has hurt short sellers, who profit from declining stocks.
• Short sellers have recorded $81B in losses this month, after earning $300B in gains in 2022.
• The rally is driven by signs of cooling inflation, a strong US labor market, and the reopening of China.

The stock market's resurgence in 2023 has been a nightmare for short sellers. These investors make money from declining stocks by borrowing shares of overvalued companies, selling them, and then buying back at a lower price later. In 2022, when markets globally took a hit, short sellers saw significant gains.

However, their luck has changed in January as the stock market made a comeback, and this has negatively impacted their profits. For instance, a Goldman Sachs index that tracks the 50 most shorted stocks in the Russell 3000 has seen a 15% return this year through Thursday, outperforming the S&P 500, which has risen by 6%. Other stocks that performed badly in 2022, such as Tesla and Coinbase, have also witnessed significant growth, with Tesla experiencing a 44% increase in January and Coinbase increasing by 73%.

As a result, short sellers are cutting their positions to minimize their losses, according to Ihor Dusaniwsky, Managing Director of Predictive Analytics at S3 Partners. Investors betting against stocks have recorded $81 billion in mark-to-market losses on their short positions this month through Thursday after earning $300 billion in gains in 2022.

The rally appears to be driven by several factors, including signs of cooling inflation, which has prompted bets among investors that the Federal Reserve will reduce interest rates in the second half of the year, thereby boosting risky assets, including stocks with high short interest, which have experienced even greater growth. Analysts believe that this has forced short sellers to close out bearish positions, resulting in what is known as a short squeeze.

"The worst performers last year are leading this year," said David Lefkowitz, Head of Americas Equities at UBS Global Wealth Management. "It does look like some re-risking and short covering."

Investors will receive an update from the Federal Reserve on Wednesday, with the central bank concluding its first two-day policy meeting of the year. The Fed is expected to raise interest rates by a quarter of a percentage point, which marks a slowdown from last year's pace. Some investors have warned that a prolonged rally of speculative assets could loosen financial conditions, setting back the Fed's fight against inflation. Others have said that a rally driven by a short squeeze is vulnerable to swift reversal if the Fed proves to be more aggressive on monetary policy than expected.

Investors who have grown more optimistic about the market's prospects say that data suggests that their worst-case scenario, a deep and prolonged recession, is less likely than it was before. The US economy has so far proven to be resilient, with GDP growing at a solid 2.9% annual rate in the fourth quarter, according to the Commerce Department.

Investors have also pointed to the strong US labor market and the reopening of China as reasons for the market's change in fortune so far this year. For investors looking to shift capital from defensive positions, the battered technology sector has been a popular place to start.

Even after its recent rally, the Nasdaq Composite still looks cheap relative to its valuation during the pandemic rally, trading at a multiple of about 22 times earnings over the past 12 months, according to FactSet, compared to a recent peak valuation of almost 37 times earnings in February 2021.

"We think that there's a lot of relative value in how beaten up some of these mega-technology companies were in 2022," said Nicole Webb, Senior Vice President and Financial Adviser at Wealth Enhancement Group. "Technology stocks look compelling because they are likely to benefit if the Fed starts to ease monetary policy."

Traders in interest-rate derivatives markets see a 92% chance that the Fed will raise rates at least twice in the first half of the year.