Goldman Sachs warns: Short covering dominates US stock market summer trend, Waller's first FOMC may become a "time bomb"

The US stock market is undergoing a technical rebound driven by short covering, rather than genuine buying from fundamental improvement. Meanwhile, the new Fed Chair Kevin Walsh is about to preside over his first FOMC meeting. Facing the complex situation of conflicting inflation and employment data, the choice of wording at the press conference may decisively affect the direction of the market.

According to Goldman Sachs derivatives strategist Brian Garrett’s latest report, hedge funds have been buying risk exposure in US stocks for four consecutive weeks, but this week’s main driving force has shifted from "increasing alpha exposure" to "reducing beta shorts." Goldman Sachs prime brokerage data shows the ratio of short covering to long buying is as high as 4.7 to 1; this structural characteristic casts doubts on the sustainability of the current rally.

Meanwhile, the bullish sentiment among US retail investors (AAII) has dropped to a one-year low. The S&P 500 has barely moved over the past month, and the market overall lacks direction and conviction.

The S&P 500 futures are currently less than 1% away from their all-time highs, with some boost from Trump’s announcement of a new agreement with Iran. However, Garrett warns that Walsh will preside over his first FOMC meeting in the context of highly conflicting data—CPI up 4.2% year-on-year, PPI up 6.5% (the highest since 2022), non-farm payrolls increased by 172,000, and the three-month average is 188,000. Although market consensus favors "keeping rates unchanged," Garrett points out that the signals conveyed at the press conference will determine sharply different market paths, and the potential impact should not be underestimated.

Short Covering Leads the Rally, Genuine Buying Signals Are Weak

Goldman Sachs prime brokerage data reveals the internal structure of this rebound: Globally, prime brokerage books are net buyers overall, but the driving force is almost entirely from closing shorts rather than active long positions. The ratio of short covering to long buying is 4.7 to 1, indicating that market participants are more passively reducing risk exposure rather than actively betting on upside.

At the single-stock level, there is actually net selling—nine out of eleven S&P 500 sectors saw net selling this week, mainly in information technology, communication services, essential consumer goods, and discretionary consumer goods. The financial and industrial sectors have had net buying for three consecutive weeks and are among the few exceptions.

Large-cap tech stocks are clearly under pressure. Garrett notes that the Mag 7 (big tech stocks) underperformed the S&P 500 by over 400 basis points this week. The Goldman Sachs trading desk continues to observe supply pressure on tech, media, and telecom sectors from institutional investors and hedge funds. The Mag 7 are being used as sources of funds for semiconductor and memory chip stocks. The software sector fell about 5% last week, dragged down by ADBE and ORCL earnings reports.

"Diffusion Trade" Continues to Evolve, Equal Weight Index Outperforms

At the market structure level, the Goldman trading desk has repeatedly mentioned the "diffusion trade" theme, believing capital is spreading from highly concentrated large-cap tech stocks to a broader market. Garrett points out, this dynamic is reflected in both "rotation" and "deconcentration" dimensions.

Goldman Sachs had proactively recommended to clients in the past two weeks the outperformance options for the equal-weight S&P 500 index (RSP) versus the market-cap-weighted S&P 500 (SPX), with at-the-money outperformance option costing 1.4% at the time; since then, RSP has outperformed by 2.4%, proving this judgment.

The Goldman basket strategy team further identifies several "catch-up" opportunities, including sectors where price gains lag behind earnings momentum, the S&P 500 excluding AI components and cyclical stocks, and shorting overvalued European defensive stocks.

FOMC Press Conference: Same Decision, Two Paths

Garrett defines the upcoming FOMC meeting as a high-risk test for Walsh. Although the market consensus is almost formed around the "hold rates unchanged" decision, Garrett emphasizes, the real variable is the signal transmission at the press conference.

He outlines two sharply different scenarios: First, if rates are kept unchanged but a tightening signal is released (the market has priced in a rate hike for January 2027), then there is a risk of triggering a strong political reaction, and the 2-year SOFR may rise about 15 basis points. Second, if rates are kept unchanged and the Fed emphasizes that supply-side inflation cannot be solved using demand-side tools, then the 2-year SOFR may fall about 8 basis points. Garrett concludes, "The same rate decision, different press conference, dramatically different outcome paths," and specifically notes the time value of S&P 500 zero DTE (0DTE) options on FOMC day is worth watching.

Recently, Goldman has published two important reports on the rates market, respectively pointing to "no rate cuts this year" and "a higher bottom for rates."

Liquidity Drought Raises Volatility Risk, Gold Turns Structurally Bearish

At the derivatives market level, Garrett notes market liquidity is currently extremely scarce—top-of-book liquidity is at an extremely low level, which is closely related to the dominance of options trading and the shrinkage of single-stock trading. Historically, such conditions have often accompanied rising realized volatility.

The spread between implied volatility and realized volatility is now at one of its lowest levels in nearly two years, so the Goldman trading desk tends to hold short-term volatility longs. One-month at-the-money Nasdaq volatility is currently about 1.6 times the S&P 500’s, approaching 15-year highs. It is worth noting that S&P 500 one-month standardized put/call skew has flattened for four consecutive days and is again near one-year lows, indicating clients are unwinding hedges and the options market has yet to show signs of panic.

On gold, Garrett points out that it has fallen about 25% from its January high, although it is still up about 25% on a 52-week basis. He believes gold saw "meme-like" speculation at the start of the year but has since returned to reality. Goldman futures team data shows CTA, ETF, and futures markets are now all net short on gold; GLD call skew is at a ten-year low, while put skew has risen to a historic high. Garrett believes the Iran agreement’s implementation may become a clearing event after gold’s months-long underperformance and recommends using risk reversal strategies (selling puts/buying calls) or ratio call spreads to position for gold upside risk.

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