Despite enduring a brutal start to the year for their portfolios thanks to a surprise market rally, two top-ranked fund managers are sticking to the bearish views that made them winners in the 2022 stock crash.

Jeff Muhlenkamp, whose Muhlenkamp Fund delivered a positive return last year, says elevated interest rates will continue to sow market havoc even though it’s likely that the Federal Reserve will engineer a soft landing. Moreover, there is a risk that the aggressive policy tightening ends with a recession, with a worst-case scenario that the S&P 500 drops a whopping 30% from Thursday’s close. His fund currently holds more than one third of its money in cash.

Muhlenkamp’s skeptical peer James Abate also sees the equity rally as nothing more than a bear-market trap. His Centre American Select Equity Fund, which beat 96% of peers in 2022 according to data compiled by Bloomberg, put on new hedges via put options in recent weeks. A four-month advance has pushed the S&P 500’s price-earnings ratio above its 10-year average at a time when corporate America’s profit machine is weakening.  

“I have difficulty in seeing how the market can move materially higher in this environment,” said Abate, aged 57. “You have an asymmetrical market where you get limited gains from P/E expansion if all goes well and you get significant declines if indeed a recession does take hold.”

Their skepticism echoes a large swath of Wall Street pros who resist embracing an advance that has lifted the US benchmark as much as 17% from its October low. While bears have been forced to unwind short positions, there are signs that few are willing to chase gains.

In fact, hedge funds tracked by Goldman Sachs Group Inc.’s prime brokerage last week trimmed their long holdings as stocks went up. The caution looks prescient this week with the S&P 500 falling as Treasury traders raise bets on how high interest rates will rise.

For fund managers who took on the world and won last year thanks to defensive positioning, the decision to hold on isn’t without pain, especially at a time when virtually all of 2022’s trends have reversed.

Abate’s Centre fund, which topped 99% of its counterparts in past three years, has lost some of its shine, in part because energy shares — its biggest industry holdings — were supplanted by technology as market leaders. Up almost 6% this year through Wednesday, it trails the S&P 500 by 1.6 percentage points, ranking near the bottom quartile among comparable funds.

The reversals have prompted Muhlenkamp to do some soul searching. A dearth of cheap-looking stocks and the muddy outlook have led his fund to park a big chunk of money in cash, a tactic that helped it deliver gains during 2022’s bear market. Now with cash sitting at 35%, the cautious positioning is working against him. The fund, which his father Ron Muhlenkamp started in 1988 with a deep focus on value, is already behind the market by roughly 5 percentage points weeks into the new year. 

“There’s very much a difference between what the market is doing and what I think it ought to be doing,” Muhlenkamp, 56, said. “If in fact we’re entering a renewable market rally, the longer I sit in cash, the worse my underperformance is going to be. The flip side is, if I put all that cash to work simply based on what I think the market’s going to do, not because of what I see going on in individual stocks, then I risk being completely wrong.”

Last year, his top three worries were: a worsening energy crisis in Europe, the dollar’s strength potentially causing turmoil in international markets, and the Fed’s tightening. So far, two of them have seen improvement — a warmer winter in Europe has eased demand for oil and natural gas, while the dollar has fallen roughly 10% from its 2022 peak. Yet the threat from the Fed persists.

“It is most likely that the market is still going to go down from here,” Muhlenkamp said. “If that unfolds, you’re going to look for some really stupid prices, because when things start going down again, people are going to unwind a lot of leverage. That generates a mechanistic selling that ends up creating ridiculous prices.”

That kind of rush for the exits was largely absent during the 2022 drawdown. In fact, Cathie Wood’s ARK Innovation ETF attracted billions of money during a 67% plunge. Notably, this year’s advance has featured a precarious revival in risky stocks, with gains more pronounced in unprofitable tech and retail darlings.

To Muhlenkamp, who’s based in Wexford, Pennsylvania, the dip-buying mentality is still alive and the market has yet to capitulate, reaching an inflection point that typically sets the stage for a sustainable rally.

At Centre, Abate also took a hard look at what he may have missed. In the New York-based investor’s view, the latest bout of market buoyancy reflected lower bond yields and better-than-feared earnings. To him, companies have refrained from spending big money on capital investments during this cycle, a distinction from past crisis periods like 2000 and 2008. That means any hit from excess unwinding is likely less damaging, allowing the economy to muddle through.

That’s not to say the danger of a recession has disappeared. And the lingering murky outlook is likely to keep the market in a wide trading range, as it has been since last June, according to Abate. Over that period, the S&P 500 was mostly stuck in a 800-point band, creating headaches for bulls and bears alike.

“We’re going to be in an environment of maximum frustration, unfortunately,” said Abate. “People have to be prepared for this lasting more than 12 or 13 months.”

This article was provided by Bloomberg News.