'Bond King' Bill Gross says stocks look overstretched - and a major recession could hit if interest rates don't drop this year

• Bill Gross struck a cautious tone on the stock market, economy, and US debt this week.
• The billionaire "Bond King" touted safer stocks over the high-flying "Magnificent Seven."

Stock valuations are stretched, a major recession is a real threat, and the US is caught in a debt spiral, Bill Gross has warned.

The billionaire cofounder of bond giant Pimco told Bloomberg on Monday that the S&P 500 trading at a record high doesn't make sense to him. The benchmark stock index's price-to-earnings ratio of about 19 is "much too high" when the real or inflation-adjusted interest rate today is a restrictive 1.8%, he said.

The Federal Reserve has hiked interest rates from nearly zero to north of 5% since early 2022 in an effort to combat historic inflation, which remained elevated at 3.4% in December. Yet stock valuations haven't materially declined, Gross noted, even though higher rates typically eat into companies' profits by discouraging spending and borrowing, and shift investor demand from stocks to safer assets like bonds and savings accounts by boosting their yields.

"Ultimately, PE ratios have to get more in balance with real interest rates which are relatively high," Gross said.

The investor known as the "Bond King" cautioned against piling more money into the so-called Magnificent Seven stocks that led the market higher last year.

"It's probably the time to cool it off a little bit and to put your money elsewhere," he said about the group of technology stocks that includes Tesla and Nvidia. Gross touted cheaper, less risky stocks in sectors like energy, tobacco, and telecoms that are paying attractive dividend yields of anywhere from 5% to 10%.

The market veteran called on the Fed to quickly loosen its grip on the economy before it snuffs out growth and sparks a downturn.

"The Fed should lower interest rates over the next six to 12 months," he said, explaining that would "basically balance out real interest rates and lower them so that the economy won't go into a significant recession."

Gross urged investors to be cautious in light of myriad domestic and overseas threats. Those range from political tensions ahead of the US presidential election this winter, to the Russia-Ukraine and Israel-Gaza conflicts, and the Houthi attacks on ships in the Red Sea disrupting global supply chains.

He also struck a resigned note on ballooning debt piles in the US and many other countries.

"It's simply a situation now where there's too much debt, and in order to keep that debt rolling and keep the economies rolling on a nominal basis, it's necessary on the part of central banks to maintain a relatively easy monetary policy and the same thing with fiscal," Gross said. "I think $1.5 trillion deficits are here to stay."

Gross' comments echo his latest investment outlook, in which he advised investors to stay in the market to avoid missing out on gains, while also being careful and avoiding the riskiest assets.