Taking on extra risk has been a very profitable move over the past couple of years. Since the beginning of March 2009, the S&P 500 is up 92% and the Russell 2000 is up 129%. Investors have more or less been pushed into riskier assets by the Federal Reserve as its low interest rates make lower-risk investments unpalatable.

But how long will the "risk-on trade" last? Not much longer, 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.

While GMO hasn't filed its SEC paperwork disclosing its first-quarter holdings yet, we can get some idea of what Grantham views as attractive blue-chip and emerging market stocks by looking at what GMO was holding at the end of last year. As far as general blue chips, GMO's major positions included Oracle, Pfizer (NYSE: PFE), Apple (Nasdaq: AAPL), and ExxonMobil. Emerging markets holdings included Russia's JSC Gazprom and LUKOIL, Brazil's Vale (NYSE: VALE) and Petrobras (NYSE: PBR), and Thailand's PTT Public. The portfolio also includes major multinationals like Philip Morris International (NYSE: PM) that aren't based in an emerging-market country but do a significant amount of business in those countries.

Obviously those positions may have changed since the last report, but large-cap blue chips have been a focus for Grantham for a while now, so it should give a general idea of what he views as the types of blue chips that investors should be focusing the portion of their invested portfolio on. 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?
Unfortunately, I find myself nodding along with Grantham. Broadly, the stock market looks far from cheap and small caps in particular look pricey.

However, those that have stumbled on my articles in the past know that my investing tends to be focused on buying high-quality companies paying solid dividends at reasonable prices and then (trying!) to practice patience. That meshes with Grantham's favorable view of higher-quality companies, but also means that I'm in no rush to sell the stocks that I do hold.

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.

That said, I -- and I'm assuming most reading this -- am not in nearly the same situation as Jeremy Grantham. At GMO, he has more than $100 billion that needs allocating, so when the number of attractive opportunities starts to fall at all, his options become a lot more limited. Since I have considerably less than $100 billion that needs to be put to work, I can still find a good number of opportunities today as long as I'm a little choosy.

And "choosy" is the operative word. Even among companies with similar metrics, valuations can vary widely. All of the stocks below have Buffett ratios (a measure similar to return on capital) between 25% and 35% and expected long-term growth between 10% and 20%, but their valuations are all over the board.

Company

Buffett Ratio

Expected Long-Term Growth

Forward Price-to-Earnings Ratio

Intel (Nasdaq: INTC)

34.9%

10.7%

10.1

Gilead Sciences (Nasdaq: GILD)

33.3%

15.4%

9.9

Whirlpool

27.3%

14.0%

7.2

Idexx Laboratories

28.0%

15.8%

29.6

MicroStrategy

26.2%

11.3%

42.9

Blue Nile

25.4%

18.6%

47.1

Source: Capital IQ, a Standard & Poor's company.

The believability of the growth estimates may account for some of the valuation discrepancy and some of these companies -- Motley Fool Rule Breakers recommendation Blue Nile, for instance -- regularly report cash flow well in excess of their net income. However, I think the table underscores the fact that the market is far from homogenous and there are still value opportunities out there.

Over the horizon
Of course while I tend to focus on large, blue-chip equities because that's where I see value, I 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 shouldn't be all that surprising considering the number of resource-focused stocks among his big holdings (Exxon, Vale, Petrobas, LUKOIL, etc).

And if you're on board with this part of his outlook, you may want to check out the special report "3 Stocks for $100 Oil." You can access the report absolutely free by clicking here.

Intel and Pfizer are Motley Fool Inside Value choices. Blue Nile is a Motley Fool Rule Breakers selection. Apple and Gilead Sciences are Motley Fool Stock Advisor recommendations. Philip Morris International is a Motley Fool Global Gains selection. Intel and Petroleo Brasileiro are Motley Fool Income Investor choices. The Fool owns shares of and has bought calls on Intel. Motley Fool Options has recommended a bull call spread position on Apple. Motley Fool Options has recommended a diagonal call position on Intel. The Fool owns shares of Apple, ExxonMobil, Oracle, Petroleo Brasileiro, and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer owns shares of Philip Morris International and Intel, but does not have a financial interest in any of the other companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.