Bull Markets Have Crushed Shorts. JPMorgan Says That Leaves Stocks More Vulnerable to Bad News

Nvidia Corporation (NVDA, -2.30%) experienced a significant peak-to-trough swing of about 7% on Thursday, ultimately closing the day down 3.5%. This movement has become a focal point on Wall Street, with futures on Friday indicating a cautious market opening.

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Market Reaction to Nvidia’s Movement

The sharp reversal in Nvidia’s stock price raises questions about whether this signals an end to the recent enthusiasm that saw the company briefly become the world's most valuable, propelling numerous AI-related stocks upwards. Alternatively, it could merely be a temporary phase of profit-taking, given that momentum indicators suggested Nvidia was significantly overbought.

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The broader market reaction to Nvidia's turnaround on Thursday, which affected a range of major technology stocks, suggests a heightened sensitivity to any emerging doubts or negative news in a market that has recently surged to record highs.

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Factors Contributing to Market Fragility

One potential reason for this fragility is the record-low levels of bearish positions in key assets, as noted by a team of JPMorgan analysts led by Nikolaos Panigirtzoglou. They explain that a decline in short interest in the two largest equity ETFs, SPY (S&P 500) and QQQ (Nasdaq 100), has supported the U.S. equity market over the past year. Short positions, which involve selling an asset with the intention of buying it back at a lower price, can also serve as hedges against long positions.

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JPMorgan analysts suggest that the reduction in short positions on these ETFs has provided support to the indices, as investors covering their short positions have contributed to upward pressure on the market. However, data does not indicate a corresponding increase in short positions in individual stocks.

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Decline in Short Positions

Short interest, measured as a percentage of shares outstanding for an equally-weighted index of major technology stocks (including Alphabet, Apple, Amazon, Meta Platforms, Microsoft, Nvidia, and Tesla), has not shown a significant increase over the past year. A similar trend is observed in an equally-weighted S&P 500 index.

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JPMorgan cites several reasons for the decline in short positions:

1. The difficulty of maintaining short positions in a rapidly rising market.
2. Increased regulatory demands for transparency, making short sellers' positions more vulnerable to being squeezed by other market participants.
3. Deterrents stemming from the 2021 meme-stock frenzy, which saw significant volatility and challenges for short sellers.

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Additionally, assets under management by short-bias equity hedge funds have sharply declined in recent years, according to Hedge Fund Research data. As short positions decrease, the proportion of equities held in portfolios by non-bank investors globally has reached its highest level since the great financial crisis.

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Implications for Market Volatility

The steady reduction in short positions has suppressed realized volatility, allowing investors with volatility-based risk management frameworks to take larger equity positions. This has effectively become a bet on continued low volatility. However, JPMorgan warns that the current low levels of short interest could pose a vulnerability for U.S. equities if negative news starts to reverse the trend of declining short interest.

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Market Overview and Upcoming Data

U.S. stock-index futures (ES00, -0.14%; YM00, -0.04%; NQ00, -0.06%) are showing slight declines as benchmark Treasury yields dip. The dollar index is higher, while oil prices remain steady, and gold is trading around $2,363 an ounce.

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Upcoming Economic Data and Events

Key U.S. economic data scheduled for release on Friday include:

• S&P flash U.S. services and manufacturing PMIs for June at 9:45 a.m. Eastern.
• May existing home sales and leading U.S. economic indicators at 10 a.m.

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Friday is also a "triple witching" day, where stock options, stock-index futures, and stock-index options contracts all expire simultaneously, coinciding with the quarterly rebalancing of major U.S. benchmark indexes and ETFs.

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Additionally, Richmond Fed President Thomas Barkin will speak on the economic outlook at 3:30 p.m.

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Corporate Earnings and Developments

Companies reporting earnings on Friday include CarMax (KMX, 1.60%) and FactSet Research Systems (FDS, 4.12%), both before the market opens. Sarepta Therapeutics (SRPT, 35.94%) shares have surged in premarket trading after the FDA approved an expanded indication for its Duchenne muscular dystrophy treatment, Elevidys.

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