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The S&P 500 is 75% Overvalued: GMO

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U.S. stocks are grossly overpriced, according to asset management firm Grantham Mayo Van Otterloo (GMO) & Company, which estimates fair value for the S&P 500 Index at 1,100 - or almost 40 percent below current levels.

In a quarterly letter published on Monday, Ben Inker, co-head of global asset allocation at GMO said the expected rate of return on the stock market index is minus 1.3 percent per year, adjusted for inflation, for the next seven years.

"[The] U.S. stock market is trading at levels that do not seem capable of supporting the type of returns that investors have gotten used to receiving from equities," Inker wrote in a report titled "Breaking News! U.S. Equity Market Overvalued!"

(Read more: Market milestones feed fear of bubbles)

"Combining the current P/E [price-to-earnings ratio] of over 19 for the S&P 500 and a return on sales about 42 percent over the historical average, we would get an estimate that the S&P 500 is approximately 75 percent overvalued," he said.

Boston-based GMO manages more than $110 billion in assets for endowments, pension funds, public funds, and foundations.

The letter came as the S&P 500 - which has risen 26 percent year-to-date - cleared 1,800 for the first time ever on Monday. However, the index failed to close above the key psychological level after comments by activist investor Carl Icahn sparked caution among investors.

Speaking at the Reuters Global Investment Outlook Summit, Icahn said he could see a 'big drop" in stocks because earnings at many companies are driving more by low borrowing costs rather than strong management.

(Read more: Icahn warns of market drop, shares give up gains)

In the same letter, Jeremy Grantham, co-founder and chief investment strategist of the firm, who is well-known for his prediction of asset bubbles, said prudent investors should already be reducing their equity bets and their risk level in general.

"One of the more painful lessons in investing is that the prudent investor or 'value investor' if you prefer almost invariably must forego plenty of fun at the top end of markets," he said.

"This market is already no exception, but speculation can hurt prudence much more and probably will. Ah, that's life. And with a Fed [Federal Reserve] like ours it's probably what we deserve," he added.

Disclosing ways in which the firm's forecast could go wrong, Inker said if the U.S. were to embark on a "golden age" or corporate investment and economic growth.

(Read more: No market bubble but some froth: Traders)

"This would solve lots of problems, including the federal deficit and unemployment...but there is sadly no evidence whatsoever that it is occurring," he said.

—By CNBC's Ansuya Harjani; Follow her on Twitter: Ansuya_H

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