"Smart money" is heavily shorting small-cap stocks! The trend of "long Nasdaq, short Russell" is sweeping Wall Street

According to the Zhitong Finance APP, after experiencing a rapid rebound since hitting a year-to-date low in mid-April, the resilience of the U.S. economy and inflation outlook are still questioned by the market under the shadow of the global trade war. Hedge fund giants, known as "smart money," are increasing their bets on the decline of small-cap stocks. The tariffs effective August 1, as stated in a letter from Trump to various countries, are generally significantly higher than 10%, pushing U.S. inflationary pressures back up, and the Federal Reserve's long-term benchmark interest rates may remain at higher levels. Hedge funds generally believe that small-cap stocks are more susceptible to uncertainties in the U.S. domestic economy.

After the strong rebound of U.S. small-cap stocks, hedge funds are collectively intensifying their short positions. With inflation and high interest rate expectations weighing down, a $16 billion "air force" has gathered, and "smart money" has begun to heavily short U.S. small-cap stocks.

Statistics from Goldman Sachs' trading department show that the short positions of hedge funds in the U.S. small-cap benchmark index—the Russell 2000 Index—reached $16 billion in July, marking one of the highest levels since 2021. From a broader perspective, although global investors' long bets on the Nasdaq 100 Index, which includes many tech giants like Nvidia and Google, are close to historical highs, the net long exposure for Russell 2000 Index futures is near its lowest level in a year.

Goldman Sachs stated that the gap between these two core position indicators is the largest on record, indicating that traditional asset management on Wall Street and algorithm-focused hedge funds are more inclined to bet on tech giants that significantly benefit from the AI boom rather than small-cap stocks known for "high risk and high return."

Many small companies have unstable balance sheets, and their financing capabilities are far inferior to those of large-cap companies in the S&P 500 index. They are also extremely sensitive to the Federal Reserve's interest rate expectations, and small-cap stocks are more sensitive to fluctuations in economic expectations compared to their larger U.S. stock counterparts. Although small-cap stocks have outperformed large-cap benchmarks—the S&P 500 index—since the low in April, some investors are skeptical about whether U.S. economic growth can remain strong enough and whether the Federal Reserve's rate cuts this year can meet market expectations to support further gains in small-cap stocks—especially as U.S. President Donald Trump continues to advocate for a radical reshaping of the global trade order through excessive tariffs.

"Fund managers generally believe that small-cap stocks are more vulnerable to domestic economic uncertainties and the cooling of rate cut expectations," said Jon Caplis, CEO of hedge fund research firm PivotalPath. "The resurgence of U.S. inflationary pressures and the possibility that long-term benchmark interest rates may remain at higher levels—these factors will compress the profit margin expectations, growth, and debt capacity of small-cap stocks, leading to a more pessimistic market outlook." If the Federal Reserve officially begins a rate-cutting cycle and the U.S. economy remains resilient without falling into recession, the upward trend in U.S. stocks is likely to continue rotating towards those small and mid-cap stocks that have suffered long-term price declines since 2022, outside of the seven major tech giants. From an investment theory perspective, these stocks are extremely sensitive to interest rate expectations, and even a slight rate cut is expected to improve their battered prices and valuations.

Some Wall Street strategists have indicated that under the macro backdrop of the Federal Reserve initiating rate cuts, the performance of small and mid-cap stocks may far exceed that of the seven major tech giants and the broader large-cap stocks. The main logic is that small and mid-cap stocks are often very sensitive to the benchmark interest rates set by the Federal Reserve; they heavily rely on floating-rate loans. Therefore, in the context of the Federal Reserve's rate cuts, this means a significant reduction in their long-standing debt pressure, which is expected to enhance profit margins and stock valuations.

Concerns About Growth Persist

In recent years, the performance of small-cap stocks in the U.S. stock market has lagged far behind that of large-cap stocks, primarily due to investors' enthusiasm for artificial intelligence, which has driven up the stock prices of tech giants like NVIDIA (NVDA.US). At the end of last year, when the "Trump trade" was just starting, small-cap stocks were among the initial major beneficiaries, as investors bet that higher trade barriers would boost demand for domestic U.S. goods and that the trade war would drag down the U.S. economy, prompting the Federal Reserve to initiate a new round of rate cuts.

However, these expectations ultimately "collectively fell short," completely offset by concerns about economic growth and "high rates that are more persistent"—an environment that poses greater downside risks for small companies reliant on external financing. Despite the Russell 2000 index rebounding 26% since its low in April, some investors continue to warn that its explosive rise may indicate overheating risk sentiment.

If the U.S. economy remains strong and expectations for a "soft landing" continue to hold firm, or if a moderate low-inflation path reinforces expectations for Federal Reserve rate cuts, the short-selling logic for U.S. small-cap stocks may be significantly undermined. Traders generally lean towards the belief that the Federal Reserve will cut rates as early as September, more likely in October, and are betting that the Fed may only cut rates once this year, possibly by 25 or 50 basis points, rather than the three cuts totaling 75 basis points that were anticipated before July.

Max Gokhman, Deputy Chief Investment Officer of Franklin Templeton's investment business, stated that considering the possibility of a "short squeeze" (a price reversal forcing short sellers to cover their positions), he has been cautiously avoiding being overly bearish on small-cap stocks. "However, given the resilience of the U.S. economy and the potential for long-term U.S. Treasury yields to rise after ten years, it is not easy to maintain a long-term optimistic view on small-cap stocks," he said in an interview