Behind this week's major volatility in the US market: hedge funds "shorting everything," buying interest in software stocks emerged on Thursday, and a "brutal short squeeze" occurred on Friday.

This week, the U.S. market experienced a rare and dramatic cross-asset class volatility, driven by an unprecedented wave of large-scale short selling by hedge funds, which then turned into a brutal short squeeze on Friday.

According to Goldman Sachs prime broker data, hedge funds’ single-day short selling volume of U.S. stocks this week reached the highest level since records began in 2016, with a short-to-long ratio as high as2.5to1. This wave of short selling not only swept through the stock market, but also impacted precious metals and cryptocurrencies, causing gold and silver to experience their largest drops in decades and bitcoin to suffer its biggest single-day crash sinceNovember 2022.

Market sentiment shifted on Thursday. Goldman Sachs observed institutional investors started buyingIGV (software sectorETF), with the fund’s shares increasing by12%on Wednesday, the largest single-day gain since2023. This signaled that the selloff may have bottomed out.

The market promptly staged a short squeeze on Friday, with Goldman Sachs’s most-shorted stock basket surging8.8%, the second-largest increase since2022. However, according to Goldman Sachs, Friday’s rally only digested about20%of short positions, suggesting the squeeze could continue.

Unprecedented scale of short selling

Goldman Sachs prime broker data shows hedge funds have net sold U.S. equities for the fourth consecutive week,with short-selling far exceeding buying.

Single stocks have been the hardest hit areas for short selling. Goldman Sachs records show that this week, nominal shorting of individual U.S. stocks hit the highest since records began in 2016, which is3.2standard deviations above the five-year average, with a short-to-long ratio of2to1. Macro products like indices andETFsalso suffered net selling, accounting for30%of the total net selling, driven entirely by short bets.

Of the 11 industry sectors, 8 experienced net selling, with the largest in dollar terms being information technology, consumer discretionary, consumer staples, industrials, and real estate. Healthcare, communication services, and utilities were the only net buying sectors.

The software sector became the focal point for shorts

The information technology sector was the worst performer and had the largest net selling, the size being the second largest in the past five years,3.2standard deviations below the one-year average, with a short-to-long ratio as high as5.4to1.

The software industry was hit hardest within the disaster area, accounting for75%of net dollars sold in the IT sector, followed by communications equipment and tech hardware. In contrast, semiconductors and IT services were the most net bought sub-sectors. Goldman Sachs data shows the software industry’s total net exposure (as a percentage of total U.S. net market value) and long-short ratio are now2.6% and 1.3respectively, both historic lows.

JPMorgan’s positioning intelligence team notes that this round of stock declines and factor volatility have hurt hedge fund returns, with all global hedge fund strategies falling an average of 1.8% this month, with long-short equity strategies down 2.0%, multi-strategy funds down2% to 2.5%, and quant strategies down1% on a market-neutral basis.

Key buying signals appeared on Thursday

The turning point for market sentiment came on Thursday. The Goldman Sachs ETF trading team observed institutional investors started buying IGV on Wednesday and Thursday.

On Wednesday, the fund’s shares increased by12%, the largest one-day change since2023. Goldman Sachs traders believed this"felt like direct buyers trying to find the bottom and a climax of participants closing shorts".

Although JPMorgan’s positioning intelligence team remains cautious towards the market, noting hedge fund leverage is still high and North American deleveraging in the past four weeks only measured at minus1.1standard deviations, Goldman Sachs’s trading team declared on Thursday that the software sector had bottomed.

Friday's short squeeze erupts

Friday’s market validated Goldman Sachs’s forecast, not only did software stocks rebound sharply, but also momentum stocks, bitcoin, and silver—other high-beta assets previously hit hard—all surged across the board.

Goldman Sachs’s most-shorted stock basket soared8.8%on Friday, the second-largest single-day gain since2022. The short squeeze swept through the market’s most battered sectors.

However, Goldman Sachs warns that Friday’s short covering at best only digested about20%of the recent backlog of short positions. This means unless short sellers double down on bearish bets, an even larger rally could occur on Monday, which would not just be limited to the hardest-hit parts of the market but could spill over into other areas.

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