Reflation-driven rally may end in crash in a few years

Two main factors drive the prices of U.S. stocks: monetary policy from the Federal Reserve and corporate earnings, which depends on the U.S. and global economy.

A stock market rally is said to be sustainable if it is justified by growth in earnings and the economy.

However, when unsustainable monetary policy -- which must be phased out and reverse at some point -- drives up stock prices, it results in bubbles and subsequent crashes, or the boom-and-bust cycle.

The first post-crisis stock market rally, from March 2009 to April 2010, was driven by loose monetary policy from the Federal Reserve and better earnings due to fiscal stimulus, cost cutting, and inventories rebuilding.

The second rally, from September 2010 and onwards, is mostly driven by loose monetary policy in the form of continued low interest rates and quantitative easing, which is basically a program that pumps newly-printed dollars into the financial system.

So when might this September 2010 reflation-driven rally end and crash? And how severe might that crash be?

In a CNBC interview, legendary investor Jeremy Grantham, who helps oversee about $100 billion at GMO LLC, said it could last for a few more years. When it crashes, the market could tank 50 percent, just like it did during the first 2008/09 crash.

Talking in hypotheticals, Grantham said the S&P 500 can go from the current level of 1,200 to about 1,500 in a few years. It could then crash and the S&P 500 could fall all the way down to 700.

Grantham thinks the fair value of the S&P 500 is at 900 at the moment, so stocks are already overvalued.

However, through quantitative easing, they will be pushed from being substantially overpriced to dangerously overpriced and into bubble territory in a few years.

As the bubble is brewing, though, and before it pops, speculators with very nimble feet can probably get away with going long stocks for a few more quarters and have a pretty good chance of winning, said Grantham.

Email Hao Li in New York at hao.li@ibtimes.com.