US stocks "fully bullish" a fantasy? Bears "target" small-cap stocks and make a whopping $13 billion profit.

Short sellers have made substantial profits by shorting a sector of the US stock market that is largely overlooked by most investors - small-cap stocks. According to S3 Partners LLC's estimate based on the average market short position, short sellers have made nearly $13 billion in paper profits this year by betting on the decline in prices of small, micro, and nano stocks. In sharp contrast, shorting mid-cap, large-cap, and mega-cap stocks has resulted in losses of approximately $140 billion, as these stocks have mostly been on the rise this year due to factors such as optimism unaffected by gloomy economic predictions, the Federal Reserve's nearing the end of rate hikes, and breakthroughs in artificial intelligence driving the surge in technology stocks.

This disparity highlights how companies like NVIDIA (NVDA.US), Meta Platforms (META.US), and Tesla (TSLA.US) have been driving most of the market gains, creating a significant gap in the stock market. Over half of the constituents of the Russell 2000 Index have declined this year, resulting in a meager 5% increase in the index, far below the 16% gain of the S&P 500 Index.

Steve Sosnick, Chief Strategist at Interactive Brokers, stated, "This year's performance is largely tied to the enthusiasm for artificial intelligence, which has disproportionately benefited large-cap tech stocks. So far, it's been a top-down winner."

From June to July, these small-cap stocks joined the market's upward trend. However, they have suffered the most in the recent pullback. S3's data shows that short sellers have estimated profits of around $9.7 billion since August. According to U.S. Bank strategists citing data from EPFR Global, investors withdrew $1.5 billion from funds focused on this sector last week, marking the largest outflow in nearly three months, as small-cap stocks took a beating. In contrast, U.S. large-cap stock funds attracted $5.5 billion in inflows.

Rob Haworth, Senior Investment Strategy Director at U.S. Bank Wealth Management, stated that one reason for the underperformance is that investors' focus on specific industries limits their interest. Short sellers have had minimal exposure to the technology sector, which has been the best-performing sector this year, while the financial and energy sectors have higher weights and belong to the worst-performing sectors. Small businesses have also been hit hardest by economic slowdown and tighter monetary policies.

Haworth said, "They also tend to be the companies most impacted by tightening credit conditions and tighter lending standards. I think that, to some extent, it creates an environment that puts a lot of pressure on small-cap stocks."

Mike Wilson, Chief U.S. Equity Strategist at Morgan Stanley, has been predicting a decline in the U.S. stock market and has also warned investors to stay away from small-cap stocks, as these stocks face a greater risk of profit margins being eroded by inflation. S3 data shows that short selling of small-cap stocks accounts for less than 10% of all short selling trades. Some strategists predict that there is still room for a rebound in small-cap stocks. For example, Jill Carey Hall, a strategist at Bank of America, has previously stated that if the economy continues to grow, market sectors that have already absorbed the risk of a recession are most likely to outperform the broader market.

However, short sellers are still entering the market. S3 data shows that in the past 30 days, they have invested $658 million in short selling small-cap stocks, an increase from the previous month. According to S3 data, last month, short sellers bet the most on Archer Aviation (ACHR.US), Air Transport Services (ATSG.US), Alteryx (AYX.US), and Sage Therapeutics (SAGE.US). The most profitable short selling trades of small-cap stocks so far this year have been in regional banks that have been hit hard. According to S3, bets on short selling Lumen Technologies (LUMN.US), Foot Locker (FL.US), and Beam Therapeutics (BEAM.US) have also paid off.