(Bloomberg) — Don’t be fooled by the stock market’s rapid-fire reaction to the news. It’s just the beginning of the first real slog in years, one that will hand a comeuppance to passive investors who once thought the only way for prices to go was up.
Most Read from Bloomberg
That’s the view of James Abate, whose Center American Select Equity Fund (DHAMX) has beaten 97% of its peers during the past three years according to data compiled by Bloomberg.
He says shares are getting less valuable due to rising interest rates and geopolitical angst. One possible outcome, as he sees it: a stock market that goes sideways for a year or more, swinging between spells of gains and losses.
“I’m of the belief that we’re in the midst of a ‘time correction,’ where the market is still having to digest a transition away from a disinflationary, low-interest rate, low-risk premium type of environment,” Abate, 56, said in an interview. “If you are a momentum trader or a passive investor, it’s going to be a period of maximum frustration.”
After peaking out on the first day of trading, the S&P 500 has fallen as much as 13%, marking one of the longest stretches of the past decade in which the market has dropped without bouncing back to a new record high. The last time the index spent more than a year without making a fresh peak was during the 2015-2016 oil crisis.
Abate’s $300 million fund has returned 13% this year, in part thanks to a hedging position the firm added at the end of last year through put options on the Nasdaq 100. After taking profits on the trade in January, the fund has shied away from rolling out new hedges.
The performance stands out in a year when many actively managed funds have struggled to navigate the latest bout of market turbulence.
Read more: Active Funds Get Crushed After Falling in Love With Their Hedges
The way Abate sees it, placing a proper price-earnings multiple on the broad market is getting tricky. With 10-year Treasury yields spiking, the S&P 500’s earnings yield — a reciprocal of its P/E ratio — has seen its premium shrink to the smallest in almost a year. Yet when adjusted for inflation expectations, stocks still look relatively cheap. The S&P 500 edged up slightly Thursday.
Still, that doesn’t mean stocks are bound to go higher. Amid all the macroeconomic headwinds, investors are likely reluctant to pay up for stocks the way they used to. And at 20 times forecast earnings, the S&P 500 is still trading at a multiple that before the 2020 pandemic was higher than any time since the dot-com era.
An adjustment “doesn’t necessarily mean that the indices are susceptible to a very sharp corrective phase, because I think a lot of the froth has come out of the market already,” said Abate. “I wouldn’t be surprised if the indices are at the same level that they are today, a year from now, but within a channel where we’re 10% higher or 10% lower as we kind of go sideways for a period of time.”
Given the backdrop, the fund manager is now focused on picking the right stocks. Recently, he trimmed holdings in travel-related stocks and transportation companies, citing their inability to sustain the post-pandemic momentum in growth. Meanwhile, he added shares with high dividends as a buffer if the fund’s economically sensitive holdings such as energy producers falter.
Broadly, with inflation running at a four-decade high, Abate favors companies that are able to pass on higher prices to customers.
“People who are thinking that we’re going to go right back to this disinflationary environment, I think, are mistaken,” he said. “We really are in a major inflection point to the way the world has been for the prior five years, and people are still reluctant to embrace it. It’s why I think there’s plenty of opportunities.”
(A previous version was corrected to fix the spelling of manager’s name.)
Most Read from Bloomberg Business Week
©2022 Bloomberg LP