The driving force behind the recent rebound in the US stock market: Short covering ignites market sentiment?

Recently, U.S. stocks have rebounded amid ongoing uncertainty, and an undeniable force is emerging behind this: it is not a recovery of confidence in the market fundamentals, but rather a "short squeeze" triggered by short sellers being forced to cover their positions, which may be conveying a false sense of optimism to the market.

The most direct evidence comes from a basket of heavily shorted U.S. stocks tracked by Goldman Sachs. This index has surged 16% this month, far exceeding the S&P 500 index's 0.7% increase during the same period, and is on track to record the best October since records began in 2008.

This rebound driven by short covering is pushing the market higher, but its essence may obscure the true sentiment of the market. With the Federal Reserve set to announce its interest rate decision on October 29, and the outlook for the Trump administration's trade agenda uncertain, the reliability of this technical rebound is being questioned. It may not be a true reflection of investors' confidence in the stock market, but rather a reluctant "surrender."

"Shorting this market is not easy; it feels like this rally will never end," said Thomas Thornton, founder of Hedge Fund Telemetry, who himself holds a small net short position in the S&P 500 and Nasdaq 100 indices:

"Every day is a heavy loss; it is both painful and frustrating."

Short Sellers Face "Epic" Squeeze, Investor Sentiment Turns Cautious

Data shows that short sellers are experiencing an unusually difficult time in October. The basket of stocks most heavily shorted tracked by Goldman Sachs has recorded an astonishing 16% increase this month, a performance that not only puts it on track for the "strongest October on record," but also highlights the immense pressure faced by short sellers. In contrast, the benchmark S&P 500 index has only increased by 0.7% during the same period.

Despite various warnings from the market over the past six months, the S&P 500 index has still delivered one of its best performances since the 1950s. Analysts believe that in the lead-up to the Federal Reserve's critical decision, some investors are scrambling to cover their short positions to avoid policy risks, and this unwinding behavior itself is adding upward momentum to the market.

Although the stock market appears strong on the surface, investors' risk-averse sentiment is quietly rising. Mandy Xu, head of derivatives market intelligence at Cboe Global Markets Inc., and her team noted in a report on Monday that while the S&P 500 index rose 1.7% last week, traders' risk appetite has reversed, and they are starting to sell call options to raise funds for purchasing downside protection. This contrasts sharply with early October when traders were more concerned about "missing out" than about declines.

Thomas Thornton added:

"Everyone is betting that the Federal Reserve will cut rates again, but many have overestimated the benefits of rate cuts to the economy, as policymakers may not be able to lower borrowing costs as significantly as Wall Street expects."

Of course, the market is not without positive signals. Strong earnings reports from several regional banks have alleviated credit concerns, pushing the S&P 500 index to within 0.3% of its all-time high. The Cboe Volatility Index (VIX), regarded as the "fear index," briefly surged to its highest level since April last week but has since fallen back below the critical 20 level on Monday

Two Types of Traders Reduce Positions Simultaneously

Deeper data shows that both quantitative funds and human decision-making fund managers are reducing their exposure to U.S. stocks. According to a team led by Deutsche Bank strategist Parag Thatte, the overall position in U.S. stocks last week saw the largest weekly decline since the sell-off triggered by tariffs in April, dropping from "modestly overweight" to "neutral."

Specifically, the movements of two types of traders are noteworthy:

• Human Decision-Making Investors: These fund managers, who make judgments based on economic and earnings trends, have shifted their positions from "neutral" to "significantly underweight." However, Parag Thatte noted that this actually clears the way for them to "buy on dips" in the future. "If corporate earnings remain strong, they will increase their purchases of U.S. stocks."
• Systematic Traders: These quantitative funds driven by computer models (such as CTAs) have also reduced their positions from high levels to "modestly overweight." The stock positions of trend-following funds have dropped to the 83rd percentile level, the lowest point in over three months. Parag Thatte added that only when the S&P 500 index falls at least 3% to 5% from current levels will it trigger large-scale selling by CTA funds.

Potential Risks Amid Speculative Frenzy

Market speculation is not only reflected in heavily shorted stocks but has also spread to other areas. Another data point from Goldman Sachs shows that a basket of unprofitable tech companies (including Roku Inc. and Peloton Interactive Inc.) tracked by them has surged 16% this month, also heading towards the best October on record (dating back to 2014).

This enthusiasm for high-risk assets lacking fundamental support has exacerbated market fragility. "If investors flock to these speculative areas related to heavily shorted stocks, they are taking on higher risks and ignoring the fundamental reasons these stocks are shorted," warned Thornton of Hedge Fund Telemetry:

"The risk of a sell-off could come very soon. What exactly that risk is, no one can guess, but it's just a matter of time, not whether it will happen."