GMO Asset Forecasts 9/30/10

In his latest quarterly letter, Jeremy Grantham says stocks are still overvalued, but are a better long-term choice than bonds--because bond prices are absurd.  Of course, you'll also want to keep a bigger-than-normal pile of cash in the hope that prices will crash and you'll get a chance to deploy it and not get screwed.
As the asset class forecast chart shows (click for a larger version), the most promising classes of stocks are "high quality" (no debt, high cash flow) and emerging markets.   Basically there's nothing attractive in bond land.
Here's Jeremy:
Should we buy overpriced stocks when bonds are
even worse?
We plan to write more substantively on this topic in the near future, but for now the short answer is that bond prices are currently manipulated, and are yielding less than any market clearing price would suggest. 
They absolutely do not refl ect the substantial fears in many quarters about inflation in the long term.  Even in less manipulated times, bond prices can be quite silly for the usual behavioral reasons, as demonstrated most clearly by the 15% yield on the 30-year Treasury in 1982!  Bonds are thus emphatically not a reasonable yardstick for measuring value in stocks. 
We use the long-term returns for stocks to decide what their fair value is.  They are currently overpriced.  Bonds are even less attractive.  Yet, remember that in a strongly mean-reverting world, you need to be careful about enthusiastically buying the less ugly of two overpriced investments.  Cash has an option value: on the chance that stocks or bonds or, better yet, both, decline, the investor will need resources from which to buy.
Specifically, here are Jeremy's general recommendations:
1) Emphasize U.S. quality companies, which are still
cheap in an overpriced world.
2) Moderately overweight emerging market equities.
3) Moderately underweight the balance of global equities.
4) Heavily underweight lower quality U.S. companies.
5) Carry extra cash reserves for a volatile market with
insecure fundamentals.
6) For the very long term (20 years) overweight
resources, particularly if they have a sharp decline. 
(This is my personal view rather than that of GMO,
which on this topic is agnostic.)
See Also: Jeremy Grantham on Gold