Oct. 27 (Bloomberg) -- U.S. stocks will “drop painfully from current levels” in the coming year amid disappointing economic data and shrinking profit margins, according to investor Jeremy Grantham.

The so-called fair value for the Standard & Poor’s 500 Index is at the 860 level, the chief investment strategist at Boston-based Grantham Mayo Van Otterloo & Co., which oversees about $89 billion, wrote in a quarterly report. The gauge fell 1.2 percent yesterday to 1,066.95. It has rallied 58 percent from a 12-year low on March 9 on rising confidence a U.S. economic recovery will boost corporate earnings.

“My guess, though, is that the U.S. market will drop below fair value” before 2010 is over, said Grantham, 71. “Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits.”

Equities have rallied globally since March amid signs government and central bank stimulus measures are helping countries exit the worst financial crisis since the Great Depression. Analysts estimate S&P 500 companies’ earnings per share will climb 53 percent in the next two years.

Grantham said his firm recently reduced equity holdings from a “neutral” 65 percent weighting in its portfolio to 62 percent, leaving “room to pull back further” should markets continue to climb. He said he favors emerging market stocks as they are likely to enter a bubble.

Previous Calls

“For once in my miserable life, I would like to participate in a bubble if only for a little piece of it instead of getting out two years too soon,” Grantham said in the report, which was posted on his firm’s Web site.

In January 2008, Grantham advised moving to cash and said credit problems with subprime mortgages would likely spread to commercial real estate. The S&P 500 plunged as much as 49 percent last year to an 11-year low in November amid a slowing global economy and mounting credit-related losses at financial institutions, which now total $1.66 trillion.

Grantham said last October stocks had become “moderately inexpensive” and investors were likely to see a “once-in-a- lifetime investing opportunity.” The S&P 500 has returned 25 percent in the past year.

‘Sucker Rally’

Not all of his calls have been accurate. The investor told Barron’s magazine in an interview published November 2003 that equities were in a “sucker rally.” The S&P 500 surged 49 percent in the next four years to a record high in October 2007.

Grantham’s view on U.S. equities being “overpriced” echo those of economist Andrew Smithers, who said on Oct. 23 the S&P 500 is about 40 percent overvalued and likely to decline as quantitative easing from central banks draws to a close and companies issue more shares.

Still, the worst performance by U.S. stocks compared with junk bonds since at least 1986 is making some investors even more bullish on equities. While owning debt in the riskiest companies has paid about the same as the S&P 500 Index over the last 23 years, bonds are returning more than twice as much in 2009, according to Merrill Lynch & Co. and Bloomberg data.

Barclays Plc and ING Groep NV had been increasing share purchases on speculation that improving corporate profits will prolong the rally in equities and shrink the gap again.

Profit Margins

Grantham and Smithers aren’t so positive on the outlook for earnings. Profit margins at U.S. non-financial companies have averaged 30.6 percent during the last 12 months, “well above their long-term mean reverting average,” according to a September report from Smithers. Smithers’ definition of profit margin refers to earnings before depreciation, interest and taxes as a percentage of output.

Economic and financial data “will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away,” Grantham wrote in his report. “It is a law of nature that strong estimates will abound after a major market rally. The earnings and economic growth estimates in such cases are usually throwaways.”

To contact the reporter on this story: Patrick Rial in Tokyo at prial@bloomberg.net

Last Updated: October 27, 2009 03:49 EDT