Funny things can happen when the market gets too worked up about something, and the emotional pendulum swings too far in one direction. Investors saw this work against them when a euphoric market in 2021 turned into a fearful bear market in 2022: Some stocks fell as much as 95%.
Artificial intelligence lending company Upstart Holdings (UPST 0.96%) was arguably the poster child for this shift. The stock soared as high as $390 before crashing as low as $12, a remarkable swing in price and sentiment.
The stock is now up 150% since May. Why? The pendulum swung too far again, and heavy short-selling created a short squeeze. Can this continue, or is the momentum about to fizzle out?
How Upstart's short squeeze began
First, a quick overview of what causes a short squeeze. A short sale occurs when a trader borrows shares of stock to sell them. Doing that creates an obligation that must be repaid in the future. To close a short sale, which is called covering a short, the trader must buy shares on the open market to repay that obligation. The short-seller's profit is the difference between the price they shorted at and the price they bought shares to cover. For example, if you short a stock at $100 per share and cover at $90, the profit is the $10 difference for every share shorted.
Data by YCharts.
As you can see, short-sellers piled on more aggressively as Upstart's share price fell. At its peak, more than 42% of Upstart's publicly available shares were sold short, which creates pent-up demand for the stock because all of these short-sellers must eventually cover their positions.
Then, the stock just needed a catalyst
Why was Upstart so heavily shorted? The company's growth and profits plummeted when it struggled to sell its loans as interest rates rapidly increased. Management began hoarding loans on its balance sheet, threatening the company's financial stability.
A squeeze happens when a bunch of short-sellers rush to cover their positions all at once, creating a tremendous demand for shares. But a rush like this often has a catalyst. For Upstart, that catalyst was the company's first-quarter earnings.
Upstart's financial performance wasn't great, but management announced that it had secured $2 billion in committed funding, and another $4 billion was announced in the following days. These funding deals give Upstart dependable buyers for its loans, helping relieve some of the funding constraints that have hurt the company over the past year. While there is work ahead, it dramatically improves Upstart's financial outlook.
Can the show go on? Yes, and here is why
It's not often that a stock is still attractive after it goes up 100% or more in weeks, but here we are. Upstart will probably remain a volatile stock, but there could still be juice to squeeze. For starters, nearly 35% of the float remains short. As the stock rises, it puts more pressure on short-sellers to cover their positions to avoid risking further losses.
Second, Upstart's fundamentals seem bound to improve at this point. With committed funding secured, which could easily continue growing with future deals, the company can begin regaining the growth it lost over the past 12 months. Upstart was previously profitable, so it's not a question of whether it can turn a profit; it's a matter of ramping the loan volume back up to what it was.
That said, investors don't need a short squeeze to justify owning the stock. Indeed, stocks that fall 95% or more rarely regain their former highs, but Upstart collapsed amid a devastating market environment, and recent financial developments potentially alter the company's trajectory.
