NEW YORK (CNN/Money) -
The manager of the world's biggest bond mutual fund predicts the Dow Jones industrial average could fall another 40 percent to 5,000 because the stock market remains stubbornly expensive despite a more than two-year decline.
Bill Gross, who manages the $6.2 billion Pimco Total Return fund, expects stocks to keep falling until the stock market's yield rises enough to make shares attractive relative to bonds.
"The market needs to yield close to 3.5 percent before it approaches fair value, and that means Dow 5,000," Gross wrote in his monthly commentary.
The yield, which is the price of an index divided by the dividends paid by companies in that index, is only 1.7 percent for the Wilshire 5000, which is historically low and a very likely indication that stocks are overpriced, according to Gross.
More stock market losses could benefit bond fund managers like Gross, whose fund is up 6.7 percent this year, a period when the Standard & Poor's index of 500 stocks is down 22 percent.
Investors fleeing the sinking stock market have poured money into bonds, which have gained for two straight years, sending the yield on the 10-year note to a 40-year low below 4 percent. Bond yields move inversely to prices. With bonds yields so low, money should start returning to the stock market, some analysts say.
But Gross, whose star has risen with the bear market, disagrees.
Writing in his September investment outlook column, the Pimco bond manager said he expected the S&P 500 to slide to 650 and the Nasdaq to "God knows where."
Since peaking above 5,000 in early 2000, the Nasdaq has fallen 74 percent. The Standard & Poor's 500 is off 41 percent from its all-time high
Gross, who said earnings have "been phonied up for years," sees the absence of conditions necessary for stock returns to exceed bond returns.
"Stocks historically return more than almost all other alternative investments but only when priced right when the race begins," Gross said. "If you start from day one with P/Es too high or, importantly, dividends too low, you will not obtain equity returns in excess of bonds."
Gross, who said he is not invested in stocks, also cited unethical business practices as a reason for his call.
"Companies have been diluting your equity via stock options claiming that management needs incentives of millions of dollars just to get up in the morning and come in to work," Gross wrote. "Then they pick you off by trading on insider information, selling shares before the bad news hits and you have a chance to get out."