A key force at the center of the stock market’s massive two-day rally is the frantic behavior of short sellers covering their losses.
Hedge fund short sellers recently added more bearish wagers in both single stocks and securities tied to macro developments after the whipsaw early April triggered by President Donald Trump’s tariff rollout and abrupt 90-day pause, according to Goldman Sachs’ prime brokerage data.
The increased short position in the market created an environment prone to dramatic upswings due to this artificial buying force. A short seller borrows an asset and quickly sells it; when the security decreases in price, they buy it back more cheaply to profit from the difference.
It can backfire when the security suddenly rallies, short sellers are forced to buy back their borrowed stocks rapidly in order to limit their losses, a Wall Street phenomenon known as a short squeeze.
If the market appeared to be rallying by quite a large amount on no real tangible news, but instead just some walking back of comments on China and the Federal Reserve by Trump, credit this phenomenon.
“Squeeze risk is real today,” John Flood, a managing director at Goldman Sachs, said in an early note to clients Wednesday.
Flood echoed the sentiment of many traders that have said the market appeared coiled for a relief rally because so many hedge funds were caught on the wrong side of this bet.
Short-covering was on display Tuesday and Wednesday as stocks shot up on signs of easing tensions on trade even though no concrete deals have been reached yet. Treasury Secretary Scott Bessent said Wednesday “there is an opportunity for a big deal here” on trade issues between the U.S. and China.
The 30-stock Dow Jones Industrial Average surged another 1,100 points Wednesday at its highs following a 1,000-point gain to end a four-day losing streak. The S&P 500 is up 3.5% week to date after back-to-back winning sessions.
Trump’s quick reversal on Federal Reserve Chair Jerome Powell also fueled the positive sentiment. Trump said he has “no intention” of firing Powell, after saying the central bank chief’s “termination cannot come fast enough” just a few days ago.
But take note the rally was quickly fading with the Dow up just 500 points at latest count midday Wednesday. The fading short squeeze boost evident at the open could be a reason for the pullback off the highs.
Also, Goldman’s Flood said hedge funds haven’t gone from short covering to outright buying on the long side, a sign that the rally doesn’t have high conviction behind it.
“I am closely monitoring to see if HF covers in macro and singles start to evolve into long buys,” Flood said. “Also want to see longer duration investors step in and buy names they view as fair value. We have not seen any of this type of action, yet.”
