Jeremy Grantham’s GMO has released its first-quarter 2009 update, and the firm says it will continue to put money back into equities, though with a cautious approach.

“Having increased our exposure to equities last quarter, we kept to our game plan and gingerly shifted our stance toward favoring riskier asset classes,” GMO states. “Our concern about the broader economic picture, however, prevented us from deploying toward more speculative areas of the market, and we did not stray far from U.S. high-quality stocks.”

Now, Grantham’s firm says its recent push into U.S. high-quality stocks will “probably represent the apex of our high quality exposure”. The firm expects its next moves into stocks will target “different opportunities”. Its equity exposure is now just shy of neutral, and the company’s next moves “will likely begin to shift our portfolios to an overweight in the coming quarters.” One area the firm likes is higher-quality Japanese companies that get much of their earnings within Japan.

“Financial results are slow to reflect the new economic reality, and … many superficially cheap stocks may fast start to look expensive as their financial position deteriorates,” according to GMO. “In that light, the Japanese market looks attractive, since it seems unlikely that the next 10 years will be fundamentally worse than the last 10, whereas in the U.S. or Europe that seems quite possible, if not probable.”

Among the other broader current strategic points GMO makes in the letter:

• Beware sovereign bonds: As the only “liquid safe haven asset” during the worst of the financial crisis, government bonds “now look dangerously over valued,” GMO states. Huge new issuances may also hurt prices. “Unless deflation is deep, prolonged, and persistent, government bond investors are likely to be very disappointed in the medium term,” GMO says.

• A bias toward high-quality stocks: Value stocks aren’t values right now, GMO states. High quality stocks, meanwhile, “trade at a slight premium to the market when historically they have traded at a much wider 18% premium to the market.”

• Increase exposure to equities, particularly to international equities: Both emerging and developed areas abroad are offering good values right now. While the better values are due to falling prices, not better fundamentals, GMO thinks it’s time to start reallocating to those areas

• A focus on conservative absolute return strategies: Such approaches can “provide equity-like returns while improving diversification through low correlations with equity markets”, GMO writes. “Try to ensure that alternative strategies are providing true diversification with low correlation to traditional asset classes.”

Overall, GMO says the current investing picture has become cloudier than it was last year, when there were three “near-certainties” in the investment world: U.S. home prices would continue to decline, U.S. profit margins would decline, and risk premiums would widen globally. “As those assumptions have played out, our certainties have faded and navigating the investment waters has become a great deal more treacherous,” the firm says. “Part of the difficulty is a result of the increasing moral hazard generated by the various attempts to reflate the global economy. Valuations for large swaths of the market no longer depend on earnings, profits, and growth, but on the size, type, and intention of government action. Investments in financial firms in particular remain particularly exposed to the whims and vagaries of Washington.”

Compounding the problem, Grantham’s firm says, is the fact that history shows equity markets overshoot on the way up and the way down. And it also shows that cheap assets get driven back to fair value by forces of competitive capitalism, while the forces that compel prices down and away from fair value are our animal spirits, and cycles of fear/greed, which are much harder to predict.

Another factor complicating things: the sheer size of the oncoming fiscal stimulus. “One can argue about the longterm effects of government spending, but in the short run, the government’s money is as green as everyone else’s and huge outlays will not go unnoticed,” GMO predicts.