DoubleLine CEO Jeffrey Gundlach

U.S. equities are “grinding higher,” according to DoubleLine Capital CEO Jeffrey Gundlach. But with tax cuts looking like they will be “really hard to get done” and other headwinds, investors need to keep expectations low, the bond king said during a conference call on Tuesday.

Gundlach favors non-U.S. stocks given the “undeniably high” valuations for the market.

“Here is what’s alarming. The price-to-sales ratio of the S&P 500 has only been higher during the dot-com bubble,” he said. This means investors “shouldn’t expect a 5% gain in the S&P 500 unless sales meaningfully pick up.”

The cyclically adjusted price-to-earnings ratio for emerging-market equities is “less than half of the CAPE for the S&P 500,” Gundlach points out.

He says that the “charge into passive investing” may be partly behind this surging price level, as more and more investors put their money into S&P index funds, for instance.

“There have been no S&P-earnings downgrades” of late, supporting the market, the fixed income specialist says.

He reminded investors that contrary to what many believe, “Fed hikes are not bad for stocks, especially when you compare stocks against bonds.”

Bonds, Fed

Yields on the 10-year Treasuries are likely to head down in the short term, Gundlach says, which is good news for bond prices.

“I expect a rally on the 10-year and the 30-year, to below 2-1/4 [percent] at a minimum on the 10-year, maybe a little bit lower than 2 and then it moves back up,” he explained. “I don’t think we’re going to see 3 on the 10-year this year.” 

As for the Federal Reserve, the market continues to be “respecting it,” and “the case for raising rates is compelling, some Fed [watchers] are saying,” according to Gundlach.

As he remarked earlier this year, he continues to believe that there will be two or three interest-rate hikes this year. “As for a June hike, we have a 50/50 shot at it,” Gundlach said.

“The bond market is saying that for 30 years inflation is going to be about 2%. I’ve never seen it much narrower than this,” he said.

Gundlach thinks inflation will decline over the rest of 2016.

“The reflation narrative may be fading in the months ahead,” he said “You wonder what the Fed will do once the inflation rate goes back below their target of 2%. We think that will happen in a few months,” he said, which will “be the real test.”  

As for how to take advantage of rate hikes, he points to holding mortgages as a portfolio strategy. The SPDR DoubleLine Total Return Tactical ETF, for instance, has large holdings of residential mortgage bonds, commercial real estate debt and agency securities.

— Check out Gundlach, Ribbing ‘Second-Tier’ Managers, Says 3% Is Rate to Watch on ThinkAdvisor.