Betting on economic slowdown, hedge funds are heavily shorting small-cap U.S. stocks

Hedge funds are increasing their short bets on small-cap stocks, as fund managers express doubts about whether the U.S. economy can continue to support further gains in this sector after a strong rebound from the April lows.

According to data from Goldman Sachs' trading division, short positions against the Russell 2000 index reached $16 billion in July, one of the highest levels since 2021. Meanwhile, investor bets on Nasdaq 100 index futures are nearing historical highs, with the gap between the two reaching an all-time high.

This trend reflects concerns in the market about the U.S. economic outlook, particularly against the backdrop of President Trump's commitment to reshaping global trade patterns. Small-cap companies typically lack robust balance sheets and have borrowing capabilities far below those of S&P 500 constituents, making them more sensitive to economic fluctuations.

Jon Caplis, CEO of hedge fund research firm PivotalPath, stated:

Fund managers believe small-cap stocks are more susceptible to domestic economic uncertainties.

The resurgence of inflationary pressures in the U.S., along with the possibility that interest rates may remain high for a longer period—these factors will impact the profitability, growth, and debt levels of small-cap stocks, leading the market to lean bearish.

Small-cap stocks have underperformed large-cap stocks in recent years, primarily due to the AI boom driving up the stock prices of large tech companies like Nvidia. At the end of last year, small-cap stocks were among the main beneficiaries of the so-called "Trump trade," when investors bet that higher trade barriers would boost domestic demand for goods.

However, concerns about economic growth and expectations for "higher for longer" interest rates ultimately undermined those hopes. Since small-cap companies rely more on external capital, the high-interest-rate environment has a more severe impact on them. The Russell 2000 index has risen 26% since the April lows, with some investors warning that this surge could be a sign of overheating risk sentiment.

Short Strategies Face Potential Risks

If economic growth remains robust, or if moderate inflation supports the Federal Reserve in lowering interest rates, the strategy of shorting small-cap stocks could be challenged. Currently, traders tend to believe that the Fed will cut rates in September or, more likely, in October.

Max Gokhman, Deputy Chief Investment Officer at Franklin Templeton Investment Solutions, noted that he has been cautious about being overly bearish on small-cap stocks, given the potential for a short squeeze—where a price reversal forces short investors to cover their positions by buying back shares.

However, considering the resilience of the economy and the prospect of long-term yields potentially rising, "it's hard to be optimistic about small-cap stocks," he added