Positioning shows the shorts are yet to capitulate, suggests Citi

Stocks go up...making life awkward for the shorts

The S&P 500's rally to fresh record highs leaves those short the market suffering notable losses - and that may mean further gains for stocks.

That's according to Citi research analyst David Chew, who in a note published Monday analyses current investor positioning in the main U.S. equity indices.

Chew observes that new record levels for the S&P 500 SPX, and near records for the Nasdaq Composite COMP and Russell 2000 RUT, have been powered by a number of supportive factors, including Friday's softer-than-expected jobs report.

"Investors viewed the weaker payrolls backdrop as reducing the likelihood of near-term Fed tightening, thereby easing a key valuation headwind for risk assets," said Chew.

A well-received corporate earnings season has boosted optimism, too, while Chew argues sentiment has been supported further by improving confidence around the prospective returns from AI-related capital expenditure and signs of progress towards a diplomatic resolution that could facilitate the reopening of the Strait of Hormuz.

Chew said that the drive higher for the market was accompanied by bullish investors increasing long positions rather than bearish investors closing their shorts. Going short can entail selling stocks, or index futures, in the hope of buying them back at a lower price,

"Positioning was predominantly driven by new risk flows rather than short covering activity, with both Nasdaq and S&P 500 registering strong improvements in normalized positioning . As a result, positioning has recovered from mildly bearish levels observed in the prior week and is now net long," he said.

"Russell 2000 positioning moved higher but changes were relatively small. It remains the most extended index exposure within our universe," Chew added.

All this action has left bearish investors, particularly those who have gone short the market, in a bit of a pickle.

Positioning risks within the Nasdaq and Russell are more finely balanced, reflecting a less extensive short base and more neutral aggregate exposure, according to Chew.

But it's the S&P 500 where most pain for the bears resides. "S&P 500 shorts are particularly vulnerable, with the aggregate short book completely offside and average per-position losses approaching 4%," he said.

But at some stage it's likely the discomfort will get to much for the shorts and they may feel forced to buy back their positions. "The size of the outstanding short base remains elevated (91st percentile on a 3-year relative), leaving potential for further upside from short-covering if the rally persists," Chew concluded.

-Jamie Chisholm