We started digging into Jeremy Grantham’s May Quarterly Letter over the weekend. Grantham is a typical underground investor: although he’s well known among institutional investors, most retail investors have never heard of him. He is the chairman of Grantham Mayo Van Otterloo, which has roughly $85 billion under management.

Grantham sounded the alarm on the credit crisis all the way back in 2006. And in a 2007 article in Fortune magazine, he warned: “In five years, I expect that at least one major bank (broadly defined) will have failed and that up to half the hedge funds and a substantial percentage of the private equity firms in existence today will have simply ceased to exist.”

What caught our eye in Grantham’s recent letter were his comments on what he terms the “Presidential Cycle.” Loyal readers will know that here at Notes we believe Washington is now the prime mover in the US economy and financial markets. Grantham offers interesting proof of our theory (emphasis added):

This Presidential Cycle effect is dismissed as an artifact by the great majority of financial academics, but they have a stalwart record of dismissing any data that implies even modest market inefficiency, and this effect implies great dollops of inefficiency. Simply summarized: since 1932, in the third year of the Presidential Cycle, the average S&P 500 return (from October 1 to October 1) is 22 percentage points ahead of the average of years one and two! And this is statistical noise? Year three is the time when, driven by politics, financial stimulus and moral hazard are applied so that the economy – particularly increases in employment – can be a little stronger in the run-up to the election in year four. In years one and two, in contrast, the system is tightened in order to leave some room for re-stimulus in the next year three (except during Greenspan’s era, when he basically could never stop stimulating and so periodically upset the applecart). It is all pretty understandable. All we have to believe is that politicians like to be re-elected and that completely independent Fed chairmen like to play ball with politicians. (Volcker of course, unlike the others, was never a ball player.) There have been no serious bear markets in year three, and many in years one and two.

Grantham, a well-known bear, says his familiarity with the Presidential Cycle has caused him to “part company” with many of his bearish allies for a while. That’s because the Presidential Cycle teaches us that fiscal stimulus and moral hazard have the power to “move the stock market many multiples of their modest effects on the real economy.”

Grantham’s central argument is that investors should never underestimate the power the Fed wields over the market through its ability to 1) boost liquidity 2) bailout speculators. This is borne out by empirical evidence. Britain has shown a bigger year-three jump on the US Presidential cycle since 1932 than the US itself. Europe and Japan have also historically shown sympathy with the cycle.

The implications of Grantham’s argument on the current market rally are huge. If relatively small liquidity injections and bailouts have had such a large effect on previous market cycles, then the unprecedented interventions by the Fed in the current case are likely to have unprecedented effects.

If the stock market is many times more sensitive to financial stimulus in the short term than the economy is, then we could easily get a prodigious response to the greatest monetary and fiscal stimulus by far in U.S. history. Second, if you don’t think there is a special, one-off, super colossal dose of moral hazard out there today, you are sadly uninformed. The moral hazard in play today is of a massively larger order than any we have ever seen.

This heady cocktail of two fingers of moral hazard plus more than a dash of liquidity could send the S&P 500 to the 1,000 – 1,100 level before the end of the year, says Grantham. But this hasn’t changed his overall bearish stance.

In a rally to 1000 or so, the normal commercial bullish bias of the market will of course reassert itself, and everyone and his dog will be claiming it as the next major multi-year bull market. But such an event – a true lasting bull market – is most unlikely. A large rally here is far more likely to prove a last hurrah … a codicil on the great bullishness we have had since the early 90s or, even in some respects, since the early 80s. The rally, if it occurs, will set us up for a long, drawn-out disappointment not only in the economy, but also in the stock markets of the developed world.