Reading the posts of a fellow columnist, Hedged In, regarding Bill Gross' recent investment outlook, reminded us of his few, but very significant contributions to stock analysis.
Mr. Gross shocked the investment world in 2002 by valuing the Dow at only 5000. Pshaw! A bond manager commenting on stocks. What does he know?
As it turned out, he knew all that he needed to. Financial theory teaches us that a stock can be broken down into a combination of a bond plus a call option.
Using the U.S. Treasury rate as the "bond yield" (in order not to belabor the point), he estimated the "bond value" of the Dow as 5000. Anything over and above that represented "option value."
Equity managers have a right to include option values when they evaluate equtiies. But they need to know that this is what they are doing. Too many of them don't.
Why did the NASDAQ go to 5000 in the year 2000, and then collapse to 1,000? Our guess is that 1,000 represented the index's bond value. The remaining 400 points represented a call option on the new economy. And call options have a nasty property called time decay; they go to zero if the things specified by the option don't occur.
Bill Gross was vindicated earlier this year when the Dow went back to 6467, which represented a gain of only 29% over 5000 in over six years. So was Alan Greenspan, with his diagnosis of "irrational exuberance" in 1996 with the Dow around 6400. One could have done better over that twelve and half year period in bonds.
More on Mr. Gross, and his interaction with our own views, in subsequent posts.