Goldman Sachs Trader Sees 8% Drawdown in AI Pair Trade, Highlights Attractive Shorting Opportunity

A top trader at Goldman Sachs has pointed out that the risk-reward ratio for shorting U.S. equities is currently quite attractive. This assessment comes at a time when there are significant valuation disparities, a situation that has only occurred three times in the post-pandemic era. The most recent occurrence was in July 2024, following a non-farm payroll report that pushed the VIX index above 60. The trader noted that the current market environment presents a compelling risk-reward dynamic, making short positions an effective hedge against potential risk events. This perspective highlights the strategic value of shorting U.S. equities in the current market landscape, where the potential for significant returns outweighs the associated risks.

The trader's insights reflect a broader sentiment among market participants who are closely monitoring the evolving economic conditions and their impact on equity markets. The extreme valuation gaps and the subsequent market reactions underscore the volatility and uncertainty that characterize the current financial environment. As investors navigate these challenges, the attractiveness of shorting U.S. equities as a risk management strategy becomes increasingly apparent. The trader's comments also suggest a cautious approach to market participation, emphasizing the importance of hedging against potential downside risks. This strategy is particularly relevant in an environment where economic indicators and market sentiment can rapidly shift, affecting the performance of equities.

The trader highlighted that since the release of the U.S. CPI report last month, the U.S. stock market has undergone changes at both the index level and in its internal structure. The Russell 2000 index has outperformed, while the Nasdaq 100 has remained relatively stable. This has sparked discussions about whether small-cap stocks are leading the rally or if large-cap stocks are lagging. Notably, more than half of the stocks in the Nasdaq have fallen below their 50-day moving average, with companies like NVIDIA experiencing consecutive weekly declines and breaking below their 50-day moving average. Goldman Sachs' "AI Winners vs. AI Risks" pair trade has also seen an 8% decline, marking its largest drawdown since April.

Currently, there is increased debate surrounding AI trading in the U.S. market, while expectations of rate cuts and accelerated economic growth in 2026 are driving broader market expansion. Seven out of the 11 sectors in the S&P 500 have outperformed the broader market since August 11, with the technology sector being the notable exception. Small-cap stocks have shown significant breadth improvement, with over 70% of Russell 2000 components trading above their 50-day moving average, compared to only 47% in the Nasdaq. This 23% difference has only occurred three times in the post-pandemic era, with the most recent instance in July 2024, following a non-farm payroll report that drove the VIX index above 60.

Combining the recent non-farm payroll data, the trader noted particular interest in the "U.S. cyclical stocks vs. defensive stocks" dynamic. When the Nasdaq and Russell 2000 diverge, this type of pair trade often exhibits a "fatter" left tail event. As this basket trade approaches its high, the trader believes that shorting here offers an attractive risk-reward profile and can serve as an alternative hedge against risk events. The trader also pointed out that the "high-yield debt-sensitive basket" tracked by Goldman Sachs has shown strong performance, with 11 out of the 12 weeks seeing gains and outperforming the S&P 500 by 20%. This basket, which includes companies with a CCC credit rating or similar fundamentals (negative free cash flow and high debt levels), recently surpassed its 2021 high. The trader attributed this performance to the upcoming rate cut expectations, which would ease the asset-liability and profitability pressures on these companies.

Despite concerns about economic growth, the overall stock market has not shown signs of worry, with more S&P 500 components rising than falling last Friday. From an overall S&P 500 index perspective, positions are not extreme, falling within the -10/+10 range, with the trader's score at +6. The trader continues to closely monitor the difference in positions between Nasdaq futures and Russell futures. Before the CPI report last month, this difference was at a historical high of +470 billion, but it has since decreased by 80 billion over the past week, marking the largest single-week decline in nearly two months. Currently, a better way to express the divergence between the Nasdaq and Russell is in the options market. The relative implied volatility of QQQ vs. IWM three-month 25Delta call options is near historical lows, indicating that the options market expects QQQ's volatility to be much lower than that of small-cap IWM over the next three months, with this difference approaching historical lows.