Stuck in the Middle: How to Play a Fairly Valued Stock Market

Last Updated Jan 17, 2010 4:50 PM EST

It's difficult to make sensible investment decisions when the public is acting sensibly. Knowing what to do when markets are grossly undervalued or overvalued is a snap - buy in the first instance and sell in the second - although emotions often get in the way and prevent us from acting as we ought to.

But what's the right move when markets are more or less fairly valued, as stocks seem to be now after their huge rally from deeply oversold levels? That's a question that Jeremy Grantham, chief strategist at the portfolio manager G.M.O. and one of the most respected figures in investment circles, has been asking himself.

"A year ago, equities globally - and everything else for that matter - were very overpriced, particularly if they were risky," he recalled in his latest quarterly review of the investment landscape. "A quarter ago, in mid-March, prices everywhere were cheap. Now they have all - or almost all - converged for a few unusual moments at fair value.

"A year ago, it was very easy to know what to be: a risk avoider. It was not so easy reinvesting when terrified, but most of us knew that we should have been doing more. But today? It's difficult to be inspired at fair value."

Grantham finds it especially difficult to muster any inspiration to buy stocks. Although the market is in a broad range that he considers fairly valued, his best guess is that the Standard & Poor's 500-stock index is worth 880 or a bit less, 10 percent or so below its present level.

When he wrote his review and the benchmark was around 950, he quoted odds of even money that it would trade above 1,000 in the next few quarters. With its approach of that milestone in the last few days, his prediction seems a much safer bet, but it also makes the risk/reward equation much less favorable.

Grantham is also concerned by evidence of excessive speculation. Stocks trading at less than $5 a share have greatly outperformed those above $50, a sign that investors are looking to take a gamble in the hope of making a quick score. He also noted that stocks with histories of highly volatile price movements have handily outpaced more stable issues.

It sounds as though he is talking himself and others into selling, but he offers reasons not to do that either, at least not yet. His main argument is that many professionals are trying to talk themselves into buying. They didn't see the rally coming, but they sure enough see it now that it has gone this far and fast, and they are worried that the market will pass them by even further.

Grantham mentioned an informal survey of investors from 150 or so institutions and noted that "those admitting to feeling nervous about underexposure to risk outnumbered those feeling too aggressive by a neat 10 to 1. [That] suggests how a speculative rally can keep going longer than reasonable investors expect."

That does not make it reasonable to act unreasonably, buying stocks with both fists this late in the game. Instead he would sell into continued strength, "taking some risk units off the table," as he puts it. He suggests moving to an underweight position in stocks if the S&P tops 1,000 and heads toward 1,100.

As for issues that he thinks should stay in your portfolio, Grantham advises concentrating on blue chips. Despite their high quality - because of it, really - they remain the cheapest asset class, in his view, and also the safest and best in the chronically anemic economic backdrop he foresees.

Once you've aligned your portfolio as he recommends, then what? Keep being sensible - and patient.

"Twiddle your thumbs, and wait to see what happens," he said. "...In our strange markets, you usually don't have to wait too long for something really bizarre to show up."