Taking on extra risk has been a very profitable move over the past couple of years.

Since March 2009, the ASX/S&P 200 is up around 40%. Over in the U.S., despite all their economic woes, the S&P 500 is up around 90%. Who needs commodities when they’ve got 0% interest rates and red hot printing presses?

But there are signs the party is coming to an end. Commodity prices have recently lost their lustre. The Aussie dollar has fallen from US$1.10 back to US$1.06, and falling. And the local stock market is off around 5% in the last 3 months.

Is the “risk-on trade” over? It could be, according to GMO’s Jeremy Grantham.

Well … maybe a little while longer

Grantham starts out his most recent quarterly letter with an extensive review of times in the past when financial markets got particularly wacky — U.S. small caps in 1974, Japanese stocks in 1989, U.S. stocks in 2000, U.S. housing in 2007, and so on.

Notably, while he saw the reversals of those crazy times ahead of most, he pokes himself for generally being too early in reacting to them.

And yet he’s ready to potentially be early on another call: getting out of U.S. stocks right now.

With a rash of factors cropping up to conspire against the global economy — the earthquake in Japan, unrest in the Middle East, etc — Grantham is concerned that without a “QE3” (a third round of quantitative easing by the Fed), riskier assets are a dicey proposition.

As he puts it: “Risk now should be more reflective of an investment world that has stocks selling at 40% over fair value (about 920 on the S&P 500) and fixed income, manipulated by the Fed, also badly overpriced.”

The GMO move

In his letter, Grantham gives a pretty clear outline of what he thinks investors should be doing in this environment:

“Investors should take a hard-nosed value approach, which at GMO means having substantial cash reserves around a base of high quality blue chips and emerging market equities, both of which have semi-respectable real imputed returns of over 4% real on our 7-year forecast. The GMO position has also taken a few more percentage points of equity risk off the table.”

Large-cap blue chips have been a focus for Grantham for a while now That said, as far as Grantham is concerned, the move right now isn’t loading up on stocks — blue chip or not — but rather holding onto some higher-quality positions while trimming the invested portion of your portfolio overall.

Run! Or, run?

So what’s an investor to do? It does seem to be a tricky time for investors, and indeed the broad economy. As a group, non-mining Australian stocks don’t appear to be particularly expensive, but they are not growing particularly quickly either.

As for the miners, much depends on commodity prices staying high, and that is something a little too difficult to predict.

Here at The Motley Fool, like Grantham, we tend to favour owning high-quality companies paying solid dividends and trading at reasonable prices.

As far as keeping cash on the sidelines, this approach generally has a natural mechanism for increasing your cash holdings — as stock prices rise, dividend yields fall and valuations go up, so there are simply fewer attractive stocks to buy.

As to whether you should sell up some of the more risky elements of your portfolio, that really comes down to your personal risk tolerance.

That said, we — and we’re assuming most reading this – are not in nearly the same situation as Jeremy Grantham. At GMO, he has more than $US100 billion that needs allocating, so when the number of attractive opportunities starts to fall at all, his options become a lot more limited.

Since most of us have considerably less than $100 billion that needs to be put to work, it’s likely we can still find some opportunities today as long as we’re a little choosy.

Over the horizon

Of course while we tend to focus on large, blue-chip equities, we wouldn’t want to short-change Grantham by skipping over his longer-term recommendation, which is resource plays and “stuff in the ground” generally.

That bodes well, in the long-term, for resource-focused stocks. In that respect, Gratham would welcome a general market downturn so he could pick up some bargains in the sector. You should too.

This article, written by Matt Koppenheffer, was originally published on Fool.com. Bruce Jackson has updated it.

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