Goldman Says Big Short Squeeze Is Step in Preserving Market Calm

(Bloomberg) -- Signs of gathering economic strength are throwing the best thinking of short sellers out the window.

A basket of 50 heavily shorted companies -- stocks that speculators bet will fall -- has jumped 16 percent since May 1, according to data compiled by Goldman Sachs Group Inc. That’s twice the return of a separate collection of companies favored by hedge-fund longs and, according to the New York-based bank, a sign that peace will last in equities.

“This rally is evidence, in our view, that investors increasingly see the potential for fundamentally distressed companies to recover in a strong U.S. growth environment even as global concerns that have held weighed on the broader equity market,” Goldman analysts including John Marshall wrote in a research note.

While firms targeted by short sellers have often done well during the bull market, rarely has their performance been this dominating, according to Goldman’s research. When it has, it’s signaled market tranquility.

Versus the hedge-fund VIP picks, the rally in the bear basket is currently two standard deviations wider than normal in the past 10 years. In past instances, the realized volatility in the S&P 500 Index was 1.2 points lower in the next month, and the average stock’s one-month volatility was 2.1 points lower.

In other words, if history is any guide, volatility will stay subdued.

“While there are many risks that have been rising in the market in recent weeks, a rally in heavily shorted names while the equity market is still below its year-to-date highs does not lead us to expect higher volatility in the coming weeks,” Goldman Sachs analysts including Marshall said in the note. “This environment has been extremely tough for long/short investors whether fundamental or quant focused.”

What’s driving the outperformance of the most-shorted stocks? For one, better-than-forecast economic data in the past three months, according to the Goldman analysts. Other factors working against bears have been a rally in high yield debt and the preference for small caps.

The proportion of shares borrowed to sell on U.S. exchanges has climbed to 3.9 percent from a 10-month low of 3.7 percent in December after reaching 4.1 percent in late August.

To contact the reporter on this story: Elena Popina in New York at epopina@bloomberg.net

To contact the editors responsible for this story: Courtney Dentch at cdentch1@bloomberg.net, Chris Nagi, Richard Richtmyer

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