Short position on Russell 2000 at four-year high as hedge funds doubt small-cap rally

The short position on the small-cap Russell 2000 index is $16 billion. Thus, the market is showing uncertainty about the resilience of the U.S. economy. But the prospect of Fed rate cuts provides some backstop, analysts believe.

The Goldman Sachs Group Inc. trading desk calculates that the short position in the Russell 2000 has reached $16 billion in July, one of the highest levels since 2021, Bloomberg adds. 

Net exposure to Russell 2000 futures sits near its lowest in a year, even as investors’ futures bets on the Nasdaq 100 are near historic highs. The gap between the two metrics, according to Goldman, is the largest ever. 

The driver is hedge funds, which are increasingly betting against small caps after a "searing" rally, as doubts linger about the resilience of the U.S. economy in the face of a global trade war, Bloomberg explains. 

Many smaller companies lack strong balance sheets and can borrow much less than companies in the S&P 500. This makes them more sensitive to economic fluctuations than their larger peers, Bloomberg notes.

“Managers believe that small caps are more exposed to domestic economic uncertainty,” said Jon Caplis, CEO of hedge fund research firm PivotalPath. “The return of inflationary pressures in the U.S. and the likelihood that interest rates will be higher for longer – all of which impact small-cap margins, growth and indebtedness – has led to a more bearish tilt.”

The Russell 2000 has rebounded 28% from its April lows. This rapid growth could be a sign of market overheating ahead of a correction. 

But the "bearish thesis" around small caps would be dented if the Fed were to start cutting rates, Bloomberg points out.

In such a scenario, a short squeeze could take place as bearish investors rush to unwind their bets by buying back shares. For this reason, Max Gokhman, deputy chief investment officer at Franklin Templeton Investment Solutions, told Bloomberg as saying he has been wary of being too negative on small caps. 

On the other hand, according to Gokhman, it's hard to remain optimistic about small caps right now, with the economy holding up and long-term yields expected to remain high.

The AI translation of this story was reviewed by a human editor.