Hedge Funds Are Ramping Up Stock Shorts to Five-Year Highs. Goldman is Warning of a Squeeze.

Hedge funds are building bets against stocks to unusually elevated levels, creating conditions that could turn a market rebound into a sharp rally as bearish investors scramble to unwind their positions.

Bloomberg reported Thursday that hedge funds' bearish stock exposure was approaching a five-year high, citing Goldman Sachs data. The buildup raises the risk of a short squeeze, in which rising prices pressure short sellers to buy back shares, potentially accelerating the advance.

Short sales have outpaced long purchases across global equities by about five to one this month. Short leverage in Goldman's prime brokerage book stood at the 99th percentile of its five-year history, indicating bearish exposure was higher than in almost all of that period.

The figures reveal a market increasingly positioned for weakness and expose a vulnerability. Investors seeking protection against falling prices can become buyers if markets move against them.

Goldman's data showed net leverage among fundamental long-short funds near a three-year low, even as gross leverage increased. Net leverage measures the difference between long and short exposure, while gross leverage combines both. The combination suggests reduced directional exposure without a corresponding retreat from overall trading commitments.

The defensive positioning follows weeks of pressure on hedge funds, particularly those exposed to artificial intelligence stocks. Global fundamental long-short funds lost 2.9% in the week through October 15, suffering losses every trading day during that stretch. Asia-focused stock pickers were down 6.8% for the first half of October, according to Goldman.

Goldman had already highlighted unusually cautious positioning earlier this month. In an interview, Mark Wilson, the bank's head of European Equity Franchise Sales and Hedge Fund Coverage, described hedge funds' net equity exposure as historically low amid volatility in interest rates and energy prices. He said higher yields and other uncertainties had prompted investors to reassess their equity risk.

Those concerns help explain demand for protection. Higher borrowing costs can weigh on stock valuations, while energy price increases can threaten corporate margins and complicate the inflation outlook. Wilson pointed to both forces in discussing the market's recent adjustment.

Short selling typically involves borrowing shares and selling them, with the intention of repurchasing them at a lower price. The difference, after costs, becomes the seller's profit. If shares rise instead, buying them back becomes more expensive. The Securities and Exchange Commission notes that potential losses are theoretically unlimited because a stock's price has no fixed ceiling.

A price increase forces some short sellers to cover; their purchases lift prices further, and additional investors face pressure to close their trades. Heavy short exposure does not establish when a rally will begin, and short positions can also serve as hedges against stocks a fund owns.