Jeremy Grantham says yes, and thinks the bear market will return in 2005.

In a stock market environment dominated by optimism, respected value investor Jeremy Grantham has spent the last few years sharing some sobering advice with investors: Begin positioning portfolios defensively this year and prepare for a market plunge, which is part of a larger secular bear market, that will likely begin some time in 2005.

"The sucker rally is still taking place, and has a good chance of continuing through the presidential election," says the 65-year-old Grantham, chairman and chief investment strategist at Boston-based institutional money manager Grantham, Mayo, Van Otterloo & Co. "But after that, I anticipate the Standard & Poor's 500 Index will fall below 775." Recently, the index stood at about 1125, within spitting distance of its peak in early 2000.

The problem now is that stocks, particularly those in the United States, are very expensive by historic standards. "Today, we have substantially the worst prospects for long-term global investment returns of my 35-year career when all asset classes are considered, particularly for U.S.-centric investors," he says. "Collectively, asset classes are simply the most overpriced they have ever been."

Grantham, who was voicing this view before the 2003 rally took off, thinks that the "presidential cycle" accounts for at least some of last year's outsized market gains. "The third year of the presidential cycle is used by the administration to attempt to stimulate the economy for year four to create a favorable re-election environment," he says. "Since 1932, there has only been one down year for the stock market in the third year of a presidential cycle." This stimulus, he says, has a moderate effect on the economy, but an "extravagant" effect on the stock market that carries over, usually to a lesser extent, in a presidential election year.

Despite this predictable pattern, even Grantham is confounded by the strength of the upturn this time around. "I was quite surprised at how quickly investors returned to technology stocks, Internet stocks and companies with no earnings," he says. "Junk bonds beat investment-grade bonds, growth beat value, and emerging company debt and equity beat everything else. There was no indicator of speculation that was not rewarded last year. That is a typical sign of a bear market rally." He says that other signs of a bear market rally, such as a low that was not particularly cheap, are also in place.

After the election, any market retreat could become exacerbated as the president and his administration dispense tough fiscal medicine to raise revenue and shrink the budget deficit. This pattern and its effect on the stock market will take hold whether or not a new administration occupies the White House in November. "The only difference is that a new administration can blame the old one for existing problems, and administer more painful remedies," he says.

Investors, he warns, should gear up for the prospect of an economic and market slowdown. "I would be reducing speculative investments through June, and getting even more conservative in the last six months of the year," he says. "In 2005 and 2006, I would look for a black hole in the stock market."

This is not the first time the outspoken Grantham has made dire predictions about the stock market while others continued to jump in with both feet. A few weeks after the market reached its peak in March 2000, Grantham predicted publicly that the Standard & Poor's 500 Index would fall from 1,500 to 750, and that the Nasdaq composite index would fare even worse. By that time his then-unpopular, value-oriented investment style had driven away billions of dollars in assets from institutional clients determined to keep pace with market benchmarks. Assets fell from a peak of $31 billion in 1998 to roughly $20 billion by March 2000. "I was surprised by the impatience some investors had during the bull market," he says. "But I was not going to pay ridiculous prices for stocks." Grantham is also somewhat surprised by the extent to which investors have returned to the firm, which now manages $55 billion in assets. "When other firms were growing, we were losing clients. And as we have grown, others have been shrinking."

Even as new money continues to come in, Grantham says he is determined to control growth. "I believe that every professional investor knows that it is an ironclad law that size reduces out-performance," he says. "But I also understand the investment world's vested financial interest in muddying the waters." Two of the firm's best-performing portfolios, Emerging Market Equity and Emerging Country Debt, closed to new investors on September 30. Grantham says he "would not be surprised" if about two thirds of his firm's portfolios shuttered their doors within five years.

Surviving A Meltdown

But the bear market Grantham foresees in the not-too-distant future threatens to offset any new money coming in from investors. To avoid ceding assets to faltering investment returns, Grantham and his firm favor strategies designed to wait out the storm. His current advice to investors:

Underweight U.S. equities. The U.S. equity market remains overvalued by virtually every measure, says Grantham. GMO's most recent seven-year real return asset class forecast calls for large-cap U.S. stocks to lose an average of 2% annually after inflation, compared with an average annual gain of 3.4% for large-cap international equities. U.S. small-cap stocks as a group will suffer annual losses averaging 1.3% compared with gains of 4.6% for international small-cap equities. The chances that small-cap or value stocks will materially buck any downward trend in 2005 or 2006 appear minimal, since both are fully valued against the market. However, a value bias should help cushion the impact of a major meltdown.

Overweight international equities relative to domestic equities, and in international equities overweight smaller value stocks. While foreign developed markets are vulnerable to a sympathetic decline if the U.S. market falls, the declines should be substantially less because of the relative cheapness of foreign markets. According to Grantham, the MSCI EAFE (excluding Japan) would need to go up 35% to close the valuation gap with the U.S.

A falling dollar should also help foreign stocks. Favorable currency translation for investors, says Grantham, more than offsets the negative impact of a weaker dollar on European exporters. International small stocks still look cheap enough relative to their markets to warrant and overweight as well, although their recent strong performance has reduced their attractiveness somewhat.

Japan remains a questions mark. "Japan is the hardest call of any equity market because it involves more political ramifications than value situations. Companies with lots of debt are being kept afloat on political grounds." Despite the uncertainty, he maintains a neutral to slightly overweight stance in that country.

Adopt a bias toward quality stocks. A year from now, investors will covet the perceived safety of classic blue-chip names as they seek shelter from the bear market storm.

Go overweight in emerging markets in 2004, but exercise caution next year. Emerging markets are still cheap in absolute terms, but are not the bargain they once were because of last year's huge move. "If the U.S. market holds up, I expect that emerging markets could rise another 30% to 40 % in 2004," says Grantham. After this year, however, he plans to pare back his emerging market position to a neutral weighting.

Stay flexible on the fixed-income side. Maintain a strategic investment in inflation-indexed bonds. Although the yields on these bonds are not as attractive as they once were, they offer some flexibility and protection in a rising rate environment.

Employ an asset allocation strategy that includes non-equity market exposures, such as commodities. Alternative asset classes provide diversification for a portfolio, since they tend to be uncorrelated with equity markets. Increasing demand for commodities from China and India should also help prices. And if the dollar goes into a spiral, real assets will probably hold their value.

Grantham is particularly bullish about timber, which he believes will see increased demand as China continues its expansion. His firm, which predicts a 7% annualized real return for the asset class over the next seven years, runs some $750 million in forestry limited partnerships that invest in over one million acres of timberland.

Financial advisors who do not wish to pony up the $5 million investment minimum Grantham's firm requires can still access GMO's investment and asset allocation strategies through the Evergreen Asset Allocation Fund, which invests in 15 core GMO portfolios. Currently, the fund has 33.8% of assets in international equities, 32.9% in U.S. equities, 27.5% in U.S. fixed income and 4.9% in international fixed income.