Barclays strategists have identified several indicators that suggest a short squeeze may be occurring in the markets.
One of the most apparent signs is the dramatic rotation from large caps to small caps, which has been overwhelmingly driven by positioning and technical factors. This trend has been particularly notable in the Russell 2000 index (RTY), whose valuation gap with large caps has nearly closed.
Following the recent softer-than-expected CPI print, markets’ expectations of rate cuts increased notably. This sparked one of the strongest rotations in decades, including a substantial shift from Big Tech to small caps, a momentum reversal, and a broadening of performance within the S&P 500.
“Overall, we find several telltale signs in the recent rally that point to this being a positioning-driven technical squeeze that triggered a significant rotation,” such as the violence of the move, the strongest spot-up, vol-up dynamic in decades, unusually high call volumes versus puts, flattening skew, and significant short futures/CTA positioning going into the unwind, strategists highlighted.
“Crowded tech positioning among discretionary funds and the frothy Big Tech June-July rally driven by multiple expansion further increased the unwind risk ahead of the rotation,” they added.
Going forward, Barclays remains skeptical about the sustainability of this small-cap rally, mainly because their fundamentals remain unconvincing, with deteriorating leverage profiles and weaker forward EPS revisions compared to large caps set to “limit further upside,” Barclays noted.
Moreover, the prevailing disinflationary backdrop makes the expected strong 2H margin inflection for small caps less likely.
“And if history is a guide, then impending rate cuts might not be the panacea, though they will serve as a relief value given the higher floating rate exposure of small caps,” the note writes.