'Bond king' Bill Gross says investors should shun stocks and bonds. Here's what he's buying instead.

By Joseph Adinolfi

Pacific Investment Management Co. co-founder and erstwhile "bond king" Bill Gross no longer thinks bonds are an attractive investment, but at least they're better than stocks.

In any case, he doesn't recommend investing in either for the long term at these levels.

"I'd pass on stocks and bonds in terms of future total returns," Gross said in his latest investment outlook, which was released Wednesday.

Instead, Gross suggested that investors embrace slightly more sophisticated strategies, like merger-arbitrage plays -- that is, when traders take a position in, or bet against, a stock that's involved in a pending transaction.

He recommended Activision Blizzard Inc. (ATVI) and Capri Holdings Ltd. (CPRI). Microsoft Corp. (MSFT) has agreed to buy Activision, and the deal is expected to close in the coming weeks. The software giant recently won a court battle with the U.S. Federal Trade Commission, which had tried to block the deal.

Capri is in the process of being bought by Tapestry Inc. (TPR), which owns fashion brands including Coach.

See: U.S. bond market is sending recession warning, and Friday's jobs report could hold the next clue, Jeff Gundlach warns

Gross also included a plug for Master Limited Partnerships, which are publicly traded and offer investors tax advantages and exposure to the oil and gas sector. However, Gross acknowledged that MLPs are "a little toppy due to oil prices that seem vulnerable to the downside."

Crude oil prices have been sliding since U.S.-traded crude hit its highest level since November late last month. West Texas Intermediate crude futures for November delivery fell to their lowest level in a month on Wednesday.

Why is Gross so bearish? Simply put, rising Treasury yields mean stocks are now looking overvalued based on their forward earnings.

He cited a chart from Goldman Sachs Group analysts that he may have modified to illustrate a troubling divergence between forward price-to-earnings ratio for the S&P 500 index and the level of real yields, which represent bond yields after being adjusted for inflation.

"As the updated Goldman Sachs chart shown below might suggest, S&P 500 forward P/E multiples have for the last 5 years been correlated to real 10 year Treasury yields with the exception of the last 12 months or so," Gross said.

Based on where yields are now, the forward price-to-earnings ratio for the S&P 500 should be closer to 12x, instead of its current level, which according to FactSet is just under 18x.

When it comes to bonds, Gross's bearishness stems from the expectation that Federal Reserve Chairman Jerome Powell won't be able to meaningfully lower interest rates any time soon with inflation seemingly stuck at a rate north of 3%.

"Personally, I don't believe Powell will be willing or able to lower short rates significantly in the face of a 3% inflation future," he said.

As for stocks, Gross is skeptical that the artificial-intelligence hype can offset the hit to equity valuations that would likely occur during a recession.

"Can AI and $2 trillion fiscal deficits going forward validate that 'it's different this time'? I'm suspicious. Unless Chair Powell and company can significantly lower real 10 year Treasury rates from 2.25%, investors may eventually realize that bonds are a better deal than clearly overvalued stocks headed into an economic slowdown/recession," Gross said.

The yields on the 10-year BX:TMUBMUSD10Y and 30-year Treasurys BX:TMUBMUSD30Y hit their highest levels since the second half of 2007 on Tuesday. The S&P 500 SPX has fallen nearly 7.5% from the closing high for 2023 reached on July 31, when it finished at 4,588.96. The index was recently trading at 4,249 on Wednesday.

-Joseph Adinolfi

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10-05-23 1213ET

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