Short-seller pain that began on Monday just became a bloodbath

New York

A DRUBBING for short sellers that went under the radar on Monday snowballed as dovish indications from the Federal Reserve handed bearish traders their worst back-to-back losses in five months.

It's a change in luck for speculators who've been raking in profits from well-chosen bets against individual stocks. As of last week, a basket of companies with the highest short interest was trading at the lowest level versus the S&P 500 in a year. Now that's unravelling amid evidence of a squeeze.

In May, "people were pressing their shorts to reduce their net exposure so they weren't so long into the sell-off," said Charlie McElligott, head of macro cross-asset strategy at Nomura. "All that adds up to be fodder for a melt-up."

While the Nasdaq 100 fell on Monday, the most-hated stocks rose. That in itself was a sour cocktail for the pros - hedge funds that employ long and short strategies suffered a loss of 1.7 per cent, tied for the worst day of the year, data compiled by Nomura showed.

It was a swift reversal from May, when equity hedge funds stood their ground relative to the equity market. While the S&P 500 fell 6.6 per cent, equity hedge funds only lost 2 per cent in aggregate, according to Hedge Fund Research. That's the third-best month on a relative basis since the bull market began.

The pain for the pessimists continued on Tuesday, as a Goldman Sachs gauge of the 50 most shorted stocks jumped 3.6 per cent.

For bullish investors who remained steadfast in their view that the Federal Reserve will juice the economy and markets with a rate cut, and that a multi-front trade war will be resolved, it was a welcome break.

The S&P 500 rose 2.1 per cent on Tuesday, the benchmark's second best day this year, pushing the gauge back above its 200-day moving average.

Faang stocks bounced back from their antitrust probe-induced pain, and auto companies also led gains after the president of Mexico said he hopes to reach a deal with the US before next week's tariff deadline.

Hedge funds entered the month with exposure sitting near the lowest level in two years after boosting bearish bets in recent months, according to data compiled by Credit Suisse.

While the cautious stance paid off during the carnage in May, the rally in their most-hated stocks may force them to buy them back to limit losses. That could be a boon for the bulls in the event of a short squeeze.

On Tuesday, US stocks saw their performance play out in perfect inverse relationship to their short interest levels. Among Russell 3000 companies, the top quintile by short sales jumped 2.5 per cent on average, more than double the gain in the bottom group, data compiled by Bloomberg showed.

As the S&P 500 reclaimed its 200-day moving average, it also reached a level that Nomura estimates would prompt trend following funds to raise equity holdings.

At 2,791, these funds would increase their exposure to 82 per cent long from 67.7 per cent at the start of the session, according to McElligott. A rally to 2,938 would spur a "max long" position, he said. The S&P 500 closed at 2,803.

Futures on the S&P 500 Index rose 0.2 per cent as of 6:45 a.m. in London on Wednesday, while contracts on the Nasdaq 100 gained 0.3 per cent and those on the Dow Jones Industrial Average added 0.1 per cent. BLOOMBERG