What a spectacular year 2003 was! For the first time in my investment career, virtually everything -- except cash -- worked: stocks, bonds, precious metals, commodities, foreign currencies and collectibles.

Although it's fun to speculate on the movement of "the market," it's rarely profitable. (My forecast for a flat/down 2003 is a prime example.) Although I was cautious last year, I was able to earn good returns via my "controversial value" and "tech spec" themes. Stocks such as

Tyco

(TYC)

,

Cendant

(CD)

,

Baxter

(BAX) - Get Report

and

Electronic Data Systems

(EDS)

provided decent trades.

Most tech specs like

Artesyn

(ATSN)

,

Openwave

(OPWV)

and

MRV Communications

(MRVC)

generated triple-digit returns. Obviously my short positions cost me some profits, but opportunity costs are much different than realized losses.

Reviewing the 2003 Bull Run

By now, everyone has opened his or her 401(k) statement and rejoiced in the market's recovery. The

S&P 500's

annual 28.5% return came as a big surprise to most investors, myself included. Because of the stunning returns for most small-cap and mid-cap stocks, most portfolios performed even better than the broad cap-weighted indices. For example, the Value Line Arithmetic Index rose 48% in 2003. From its 2002 autumn low, this composite has appreciated about 95%. Clearly, a massive bull run has already occurred in price -- if not in time.

Charging of the Bulls
The Value Line Arithmetic Index has climbed about 95% from its fall 2002 low

Source: StockVal

Unfortunately, high returns today result in lower returns in the future. The doubling of the average stock from the bottom 16 months ago has removed much of the investment merit in shares. Speculative fever may provide short-term momentum for equities, but prices reached in a buying panic crescendo will not be sustained. To the extent that we're in a bull market, it's probably closer to its conclusion than its beginning.

Such strong price action has driven valuations to extremely high levels in aggregate. The large indices now trade for 18 to 19 times estimated 2004 profits. That's well below the bubble levels of 2000, but this valuation parameter should provide some headwind to stock prices. Also, the average stock, as represented by the Value Line Median P/E, trades for 19 times profit. This ratio has never been materially higher and is well above its 2000 trough. The cap-weighted indices have been expensive for all of the past seven years, but small-caps and mid-caps have had periods of depressed valuations. Not now.

Value Line P/E

Source: Value Line

The market must also contend with the fact that the current earnings estimates for 2004 imply record profit margins for the index as a whole. Corporate profit margins have indeed recovered, but now that a significant cyclical margin expansion has occurred, earnings growth must slow to levels approaching corporate revenue growth, or mid-single digits. Stocks usually struggle under slowing growth rates, especially if they're expensively valued and interest rates are rising.

I don't mean to contend that share prices will collapse in 2004. Positive news and price momentum will keep investors interested in buying. We're still seeing depressed interest rates, strong corporate profit, favorable tax rates and healthy cash flows into equities. Even a skeptic like me must acknowledge the legitimate, positive factors supporting the current bull run.

However, stock prices generally peak when valuations are high and the news flow is very good (just as they bottom when valuations are low and news is bad). How much more expensive stocks can become in the short run is anyone's guess. Look at what happened in crazy days of 1999. But the probability of another 48% return in the Value Line Arithmetic Index does seem remote.

What's Next?

The consensus now expects a front-end-loaded return of around 10% for 2004. As we all know that the consensus is usually incorrect, how will 2004 play out? Possible surprises include a major move in either direction, but that seems unlikely. High valuations represent the chief obstacle for another big up year, while big down years very rarely happen after up big years like 2003. However, if a significant rally occurs in the seasonally strong first half of 2004, I'd expect it to represent the year's high.

The real surprise would be modest annual returns, which also encompass a major correction in the first half and significant rally in the second half. My best guess would be this scenario, representing a relatively flat year.

This Value Line chart reveals the historical appreciation potential of the average stock in that universe. Now at 45% over a three- to five-year period, it has rarely offered less upside to the average stock. In fact, just eyeballing the chart shows a good market-timing sell signal.

Value Line Appreciation Potential

Source: Value Line

Regardless of the broader market's actions, I follow a rigorous, deep-value investment philosophy and process, which forces me to buy cheap and sell expensive. Most of my holdings have hit their sell valuation targets, and new purchase ideas are hard to come by in this market environment. Because of this, my new hedge fund is mostly in cash. I won't play the greater-fool trade for the sake of participating in the latest rally.

The market is becoming too speculative, suggesting a near-term correction. Valuations aren't as ridiculous as they were during the bubble's glory days, but some sectors are very aggressively priced at huge revenue and profit multiples. Stocks are once again exploding on analyst upgrades, contract announcements and even that fundamentally critical development: the stock split.

Before investors get caught up in an orgy of greed, they'd do well to recall how they felt just a few short quarters ago. Enjoy the surprising bull market, but remember, after a period of such substantial returns, the risks to your portfolio increase. And you thought this investment game was easy.

At the time of publication, Marcin was long MRV Communications, although positions may change at any time.

Robert Marcin is the founder and general partner of Defiance Asset Management. Formerly, Marcin was a partner at Miller, Anderson & Sherrerd and a managing director at Morgan Stanley, where he managed the MAS Value fund (currently Morgan Stanley Institutional Value). Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Marcin appreciates your feedback and invites you to send it to

robert.marcin@thestreet.com.