If you haven't seen it yet, the latest quarterly letter from Jeremy Grantham is well worth a read.
Mr. Grantham, chairman of global money management firm GMO, has been opportunistically bullish lately - meaning that he thinks shares are actually overvalued, but that the stock market is nutty enough to keep rising. Now, he thinks that the path of least resistance for the S&P 500 is to rise to a new high above 1500 over the next 18 months or so.
That's because the stock market, in his view, cares far more about low interest rates and monetary policy promises from the U.S. Federal Reserve than it does about the economy. Which is to say, the market is behaving a little nutty, and the Fed should take most of the blame for what could be another painful setback some time ahead.
"So now, [Fed Chairman Ben]Bernanke begs us to speculate, and we are obedient. Despite being hammered down twice in 10 years and getting punished for speculating, we again pick ourselves up off of the canvas and get back into the good fight," Mr. Grantham said in his letter.
"Speculators are not stupid. They see that after each crash, a long, artificial period of low rates and easy financial borrowing has been delivered. They see that Bernanke is an unreconstructed Greenspanite in that he refuses to address bubbles, but will leap to help ease the pain should a bubble break."
Despite thinking that the 13-month old bull market could have plenty more room to run, Mr. Grantham maintains that fair value for the S&P 500 is about 875, or about 28 per cent below its current level.
How does he reconcile this apparent contradiction? If the economic recovery is slow and unemployment falls only modestly, Mr. Bernanke will almost certainly keep rates at relatively low levels, which will drive stocks up modestly higher.
But if the recovery merely limps along - which he thinks is likely - then Mr. Bernanke will keep rates low quarter after quarter, causing the formation of another dangerous bubble in equities.
"In that environment, Bernanke will do nothing to let the air out gently. His lack of anti-bubble action is pretty much guaranteed," he said. "The end of such events is always hard to predict, but usually bubbles break for almost any reason when they are big enough. Of course, the larger the asset bubble, the bigger the shock to the economic and financial system."
Investors, then, should be hoping for a third option: The economic recovery is broad and sustained, which forces interest rates higher. In this case, U.S. stock prices would fall before a bubble is formed - though the decline among global stocks wouldn't be disastrous and the impact on the global economy would be limited.
"So what do I think will happen? That's easy: I don't know," Mr. Grantham said. "The general conclusion is that the line of least resistance is a market move in the next 18 months or so back to the old highs, say, 1500 to 1600 on the S&P 500, accompanied by an equivalent gain in most risk measures, followed once again by a very dangerous break. If that happens, rates will still be low and thus diffi cult to use as a jump starter, the financial system will still be fragile, and the piggy bank will be more or less empty."