Behind the big fluctuations in the U.S. market this week: hedge funds "shorting everything," buying interest in software stocks began on Thursday, and a "brutal short squeeze" on Friday

This week, the U.S. market experienced rare and severe volatility across asset classes, driven by an unprecedented large-scale short-selling action by hedge funds, which then evolved into a brutal short squeeze on Friday.

According to data from Goldman Sachs' prime brokerage, hedge funds set a record for the largest single-day short-selling of U.S. stocks since 2016 this week, with a short-to-long ratio reaching as high as 2.5 to 1. This wave of short-selling swept not only the stock market but also affected precious metals and cryptocurrencies, leading to the largest declines in gold and silver in decades, while Bitcoin faced its largest single-day drop since November 2022.

Market sentiment turned on Thursday. Goldman Sachs observed that institutional investors began buying IGV (software sector ETF), with the fund's shares increasing by 12% on Wednesday, marking the largest single-day increase since 2023. This signal suggested that the sell-off might be nearing its bottom.

On Friday, the market saw a short-covering rally, with Goldman Sachs' most shorted stock basket soaring by 8.8% in a single day, marking the second-largest increase since 2022. However, according to Goldman Sachs' analysis, Friday's covering only absorbed about 20% of the short positions, indicating that further short squeeze action may continue.

Unprecedented Scale of Short Selling

Data from Goldman Sachs' prime brokerage shows that hedge funds have net sold U.S. stocks for the fourth consecutive week, with the scale of short-selling far exceeding buying.

Individual stocks became the hardest hit by short-selling. Goldman Sachs' records indicate that the nominal short-selling scale of individual U.S. stocks reached the highest level since 2016 this week, equivalent to 3.2 standard deviations above the five-year average, with a short-to-long ratio of 2 to 1. Macro products such as indices and ETFs also faced net selling, accounting for 30% of the total net selling scale, entirely driven by short-selling.

Out of 11 industry sectors, 8 experienced net selling, with the largest dollar-denominated scales including information technology, consumer discretionary, consumer staples, industrials, and real estate. Healthcare, communication services, and utilities were the only sectors with net buying.

Software Sector Becomes the Focus of Short Selling

The information technology sector was the worst performer and saw the most net selling, with selling scale being the second largest in the past five years, equivalent to 3.2 standard deviations below the one-year average, and a short-to-long ratio reaching 5.4 to 1.

The software industry was the hardest hit within the hard-hit sectors, accounting for 75% of the dollar net selling in the information technology sector, followed by communication equipment and technology hardware. In contrast, semiconductors and semiconductor equipment, as well as IT services, were the sub-sectors with the most net buying. Goldman Sachs data shows that the total net exposure of the software industry (as a percentage of total net market capitalization in the U.S.) and the long-short ratio are currently at 2.6% and 1.3, respectively, both hitting historical lows.

JPMorgan's position intelligence team noted that the recent stock decline and factor volatility have weighed on hedge fund returns, with all strategies globally averaging a decline of 1.8% for the month, including a 2.0% drop in long-short equity strategies, a 2% to 2.5% decline in multi-strategy funds, and a 1% drop in quantitative strategies on a market-neutral basis.

Key Buying Signal Emerges on Thursday

The turning point in market sentiment occurred on Thursday. Goldman Sachs' ETF trading team observed that institutional investors began buying IGV on Wednesday and Thursday The fund's shares increased by 12% on Wednesday, marking the largest single-day change in 2023. Goldman Sachs traders believe this "feels like direct buyers trying to find a bottom and participants may be closing out short positions at a peak."

Although JPMorgan's positioning intelligence team remains cautious about the market, pointing out that hedge fund leverage is still high and the North American market has only de-leveraged by a negative 1.1 standard deviations over the past four weeks, Goldman Sachs' trading team clearly stated on Thursday that the software sector has bottomed out.

Friday's Short Covering Rally Erupts

On Friday, the market validated Goldman's judgment, not only did software stocks rebound sharply, but momentum stocks, Bitcoin, silver, and other previously battered high-beta assets also surged across the board.

Goldman's most shorted stock basket skyrocketed by 8.8% on Friday, marking the second-largest single-day gain since 2022. This short covering affected the most beaten-down sectors in the market.

However, Goldman warned that Friday's short covering at best only absorbed about 20% of the recent short position backlog. This means that unless short sellers double down on their bearish positions, a larger-scale rebound could occur on Monday, not only limited to the parts of the market that have fallen the most but potentially spreading to other areas