A stock market bottom could be right around the corner as short-sellers hesitate to add to their bearish bets against equities, according to a note from S3 Partners.
The short-selling research firm said short-sellers are sitting on nearly $300 billion in mark-to-market profits this year as the S&P 500 and Nasdaq 100 fell more than 20% to officially enter a bear market for the first time since March 2020 .
Recent data showed that short interest declined by about $75 billion in June to $908 billion, with all of the decline being driven by falling stock prices. The falling short interest was partially offset by a $20 billion increase in new short-selling, according to the note.
That’s a big drop from the $65.5 billion in new short-selling that entered the market in May, with bearish investors hesitating to press their winning bets.
“This may be a sign that short sellers are sensing that a market bottom is near, and they are satisfied seeing their overall short exposure shrink as the market value of their existing short positions decline ahead of what may be a possible market rally,” S3 Partner’s Ihor Dusaniwsky said.
Whether the next stock market rally is simply another bear market rally or if it is the real deal remains to be seen, but short-sellers will play a role in that outcome no matter what.
That’s because short-sellers can drive buying pressure in stocks if they get squeezed out of their position and are forced to close out their losing bet. Remember, short-sellers borrow stock to initiate their bearish bet. To close out a losing short-bet, short-sellers are forced to buy back the stock.
“With a pocketful of mark-to-market profits already earned by short sellers they will be able to weather short-term bear rallies and hold onto their positions without being squeezed,” Dusaniwsky said.
A prolonged rally that sees considerable upside will be necessary to squeeze short-sellers out of their positions and convince them to close out their positions, turning them into stock buyers, according to S3.
“When the market begins to rally, long buyers will be standing alone on the bid side of the market driving up stock prices until short-sellers are forced to join them when they are squeezed into buying-to-cover,” Dusaniwsky concluded.