GMO cofounder Jeremy Grantham thinks seven lean years are ahead for the stock market, but believes the market could rally higher in the nearer term and at least one particular asset class will outperform. 

That was the crux of his message as a speaker yesterday at the Morningstar Investment Conference 2009 in Chicago.

A bear in 1998 who predicted that the Standard &Poor's 500 Index would deliver negative returns for 10 years, Grantham says he understands why today's bears feel the S&P is still too high. In other recessions from 1930s on, the S&P bottomed at levels that would be the equivalent today of between 300 and 450 and it hasn't gone that low this time, he says. Now it's trading around 900, which Grantham thinks is fair value.

But Grantham says he's parted ways with most bears. The global, massive and rapid stimulus that's followed the financial system collapse is " a pretty good excuse" why the S&P won't hit those lows reached in other recessions, he believes.

Instead he thinks it could scream to 1100. Between the stimulus "that's beyond our wildest dreams" and the U.S. government's approach of moral hazard-meaning that "if anything goes wrong we will do anything to bail it out," we should be in for more of a rally. Also, he says markets usually do well in the third year of the Presidential cycle, when whichever administration is in office usually is successful at bringing unemployment down.

The rally "will have nothing to do with reality. All we need is a glimmer of hope" that the economy is turning around for the market to go higher, he says.

However, the major systemic problems in the global financial system won't be corrected so quickly. "Lying beyond the speculative rally are seven lean years," he maintains.

Grantham says the lean years will be caused in part by a huge mismatch among countries around the world: The Brits and Americans need to save more, while the Germans, Japanese and Chinese need to spend more. The developed world is running out of people to contribute more manhours and its GDP growth rates are falling. GDP growth will be 2.25% in the U.S. if we are lucky, while it will be 4.5% in emerging markets, he maintains.

The result? Emerging markets "will be seen as the only game in town," he says, and they could deliver a premium of 3 to 1 going forward.

But eventually, emerging markets will become the next big bubble, he believes. "You have to play bubbles," he says, "but all bubbles break."

Meanwhile, with the S&P already having reached fair value, Grantham says, many investors are now trying to catch up. "It's what happens. Everyone who is left behind takes a deep breath and tries to do damage control," he says.

That often means throwing money iin at once, and a lot of investors have been doing that by buying banks trading at under $5, creating a "junk rally" that has pushed that group up 140% off its low, Grantham says.

But since the market already is fairly valued, he adds, it would be better for investors to have a simple plan to take what they want to put in, divide it by 15 and invest it in equal amounts over as many months. "You can't lock yourself in to praying for a major setback that may not happen," he says.