A few weeks ago, we reported that far from representing improving fundamentals, blockbuster earnings or a stronger economy, the “second quarter has been just one giant short squeeze.” As we noted at the time, Goldman’s prime desk disclosed that funds had aggressively covered the most crowded short positions, and as we showed in the chart below, stocks with the highest short interest relative to float outperformed their peers in most sectors. The outperformance was particularly dramatic in the Energy sector, which experienced a large increase in hedge fund net positioning during 1Q and has been the best-performing equity sector thus far in 2Q.
And the punchline: since the start of 2Q, large-cap Energy stocks have returned 15%, small-cap Energy stocks have returned 24%, and the most heavily shorted Energy stocks have returned 30%. In short: the biggest outperformers this quarter were those “most hated” names that saw the biggest short squeeze, a strategy that has been a guaranteed generator of alpha since 2012 when we first recommended going long a basket of the most shorted names.
In the meantime, we continued our observations of what is shaping up to be a historic short squeeze…
“Squeeze TFD” pic.twitter.com/nDFTXxuBCc
— zerohedge (@zerohedge) June 6, 2018
… with others also chiming in eventually:
Ouch! Hedge got squeezed most of the times in the past year. Thomson Reuters Most Shorted Index has gained 25% since Jun 2017 vs an S&P 500 rise of ~14%. Shares in some heavily shorted stocks rallied Monday w/Tesla, Chipotle, Hertz, Avis Budget seeing strong gains. pic.twitter.com/f8n8y3q9qd
— Holger Zschaepitz (@Schuldensuehner) June 11, 2018
Fast forward to today, when Goldman – no longer able to peddle some theory that stocks are rising on their own fundamental merit – admits that stocks with the highest short interest have rallied 8.1% more than the most popular hedge fund longs over the past 6 weeks.
Which is a delightul confirmation of what we said one month ago, when in addition to listing the top 50 hedge fund longs, we also listed the top 50 shorts and said “for those who are convinced that it’s only a matter of time before a massive squeeze sends the most shorted names soaring, here is the list of the 50 stocks representing the largest short positions among hedge funds.”
Well, a “massive” short squeeze is precisely what happened next.
Some more details from Goldman on the event of the past month:
This is a 2 standard deviation move when compared to the past 5 years. These “Most Shorted” names are predominantly Small-Cap, Consumer Discretionary, Domestic focused names. This rally is evidence, in our view, that investors increasingly see the potential for fundamentally distressed companies to recover in a strong US growth environment even as global concerns that have held weighed on the broader equity market. This environment has been extremely tough for long/short investors whether fundamental or quant focused. In this note, we examine the key drivers and study the prior instances of short squeezes of a similar magnitude to assess what is likely to happen next.
And while Goldman did not tell its clients to go long the most shorted stocks a month ago (only we did), it is now more than happy to explain “what happened” and what is driving the squeeze:
- Strong US Growth and upside surprises: Our Economists 1. see US growth running at 3.8% (Q2 GDP Tracking Estimate) and data over the past three months has surprised to the upside by 0.5 st devs (MAP score). Strong growth increases the probability that fundamentally challenged companies survive and thrive.
- High Yield rally: HY credit has rallied steadily over the past several months suggesting that riskier US companies have easier (or at least lower cost) access to funding. The rally in HY has been more than just beta as it has outperformed Investment Grade credit and broad equity indexes significantly, even on a risk adjusted basis.
- Sector/Size/Domestic Exposure: Many of the companies in the “Most Shorted” basket (rebalanced monthly by our colleagues in the securities division) are small-cap, domestically focused names with a heavy weight in the Consumer Discretionary sector. Names in the Hedge Fund VIP basket created by our Portfolio Strategy team are relatively weighted towards Technology (42% of weight) and International names. Most shorted names have a median market cap of $2b vs. Hedge Fund VIP names at $69b.
- M&A excitement: The basket of stocks our analysis 4. see as M&A targets (GSRHACQN) have outperformed the SPX by 4.8% over the past six weeks, suggesting investors are increasingly focused on companies that could be acquired. Several of the companies in the “Most Shorted” basket have been discussed in the media as potential M&A targets
So having missed a mega squeeze (if only for its clients, its prop desk is a different story), Goldman is now all too happy to provide advice on what happens next, as follows:
Over the past 5 years, the “Most Shorted” Basket has outperformed the Hedge Fund VIP basket by more than 1 standard deviations in only 11% of the 6-week rolling periods.
We look at these instances and analyze what tends to happen over the subsequent month from a stock return and volatility perspective. We find that:
- Volatility is likely to decline: On average, SPX 1 month realized volatility was 1.2 points lower in the following month; average stock 1 month realized volatility was 2.1 points lower. This suggests that a rally in fundamentally challenged companies tends to lead to calmer markets. A decline in volatility would increase Sharpe ratios for equity investors in the coming weeks, all else equal.
- Equity more likely to rise than fall: We find that Hedge Fund VIP names were more likely to rise following this magnitude of short squeeze signal and outperform the “Most Shorted” names. The GSTHHVIP was up 2.0% on average in the subsequent month (a 0.6 standard deviation move) compared with heavily shorted names, which were up 1.4% in the subsequent month. This suggests that there is a mean reversion between the two indexes, but not a mean reversion in the market on average.
Which brings us to Goldman’s conclusion:
While there are many risks that have been rising in the market in recent weeks, a rally in heavily shorted names while the equity market is still below its YTD highs does not lead us to expect higher volatility in the coming weeks.
Our advice: do precisely the opposite of what Goldman suggests (but keep pressing those shorts as there are still many hedge funds who haven’t puked just yet).
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