NEW YORK ( TheStreet) -- Last year it looked like fund manager Grantham Mayo Van Otterloo had missed the boat. Led by founder and chief investment strategist, Jeremy Grantham, the firm had become convinced that stocks and bonds were overvalued. To avoid trouble, GMO portfolio managers had dialed down risk and shifted to cash. GMO Global Balanced Asset Allocation ( GMWAX) had more than 20% of assets in cash. That held back returns at a time when stocks were climbing. During 2010, the fund lagged 84% of its competitors in Morningstar's world allocation category. Wells Fargo Advantage Asset Allocation ( EAAFX), which is also run by GMO, lagged 85% of its peers.But with the markets sinking lately, the defensive stance has begun to pay off. During the past three months, GMO Global Balanced has outpaced 88% of competitors. GMO has long followed a strict value discipline. Comparing current valuations to historical levels, the firm overweights cheap assets and avoids expensive ones. The approach often works. But in a recent letter to shareholders, Jeremy Grantham conceded that his moves are usually early. In 1986, he dumped all Japanese stocks in foreign portfolios, a bold move at a time when Japan was flying high. For three years, it looked like Grantham was wrong -- and then Japanese markets cratered. In 1998, GMO again went against the grain, avoiding red-hot technology stocks. Some clients howled and fired the manager. Those who stayed with the funds were rewarded when the Internet highflyers crashed and many GMO funds outdid competitors by wide margins. More recently, Grantham protected shareholders by warning of the housing bubble well before it burst. As a result of his timely calls, Grantham has gained more assets and a wide following in the media and on Wall Street. But each time GMO proves to be early, it loses shareholders who grow impatient with the manager. With returns lagging in 2010, many investors threw in the towel. During the past year, GMO funds have suffered $3.4 billion of outflows. These days GMO is generally gloomy about the outlook for the markets. "We don't think there are many ways to make a lot of money today," said Ben Inker, head of GMO's asset allocation strategies, in a presentation at the recent Morningstar Investment Conference in Chicago. As part of its regular forecasts, the firm predicts how different assets will perform in the next seven years. According to the current forecast, U.S. bonds will return 0.1% annually after inflation, while foreign bonds will lose 1.3%. Speaking at the Morningstar conference, Inker said that he only pounds the table for government bonds when they meet two conditions: They must yield more than 2% above inflation, and government policies must be sustainable. Almost every country around the globe fails on one or both counts, he said. In Greece and Ireland, the yields are high, but the government policies are likely to blow up. In Canada and Norway, policies are sustainable, but the yields are too low. The U.S. fails to offer either sustainable policies or reasonable yields. Inker argued that U.S. small-cap stocks have become overvalued after leading the markets for much of the past decade. In the next seven years, small caps will lose 2.7% annually after inflation, according to the GMO forecast. High-quality blue chips, which have lagged in recent years, will do better, returning 4.3%. That is well below the historical U.S. equity return of 6.5% after inflation. The forecast says that emerging market stocks will gain 5.1% annually. Inker said that even after the rally of recent years, emerging markets stocks are still modestly priced. "The reason we own them is that they are trading at 12 to 14 times earnings, and that's not bad," he said. Inker cautioned that the emerging markets present hazards. The real estate markets are overheated in China, and the country cannot continue spending so heavily on cement and other fixed investments. But by sticking with low-priced stocks, investors can avoid the worst dangers.
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