The market has had a slam-dunk run since the fall and nearly every sector has participated. Internet stock analysts are back speculating about how far this move can go. Small-caps are smoking, even businesses with poor fundamentals. The Value Line median P/E ratio is pushing multiples in the 20s once again.

I think it's time to rein in some optimism on the long side. Despite the tendencies for the well-documented seasonal strength into the spring, I'm getting concerned about the market's prospects, especially next year's second half.

I'm not yet turning outright bearish; this is simply some year-end house-cleaning. My long portfolio still contains many of the value names I owned for most of the year: homebuilders, managed care and technology turnarounds, as well as selected one-offs in energy, retail, financial and industrial stocks.

Portfolio Wellness

The managed-care stocks have solid fundamentals and strong charts, and still boast reasonable valuations. My favorite, WellPoint ( WLP), trades for only 12 to 13 times 2006 profit estimates. The company just consummated a large merger that gives it dominant market share under the Blue Cross/Blue Shield brand in many states. The sector also is in the sweet spot of its normal seasonal rally.

I continue to prefer the homebuilders, which should benefit from a healthy stock market and economy in 2005. The housing market should cool materially as we progress through the year, and this is good for the stocks. My companies have established large land positions, which assure them of significant market share gains. I expect healthy revenue and profit growth despite the tempered real estate environment.

My favorite name in the group now is Pulte ( PHM). The company has one of the best organic revenue growth stories in the sector with its demographically driven play in active adult communities. The company has strong growth in new community openings, around 20%, for 2005. At 6.5 times profits, the shares could reacquire a sector-leading P/E like Toll Brothers ( TOL) or NVR ( NVR) and trade up to multiples of 9 or 10.

Depressed Drug Names

After avoiding the debacle in the drug sector, I've initiated positions in a few beaten-down large-cap names (the big uglies) with very low valuations as well as some small companies.

A favorite here is Impax Labs ( IPXL), an emerging generic company specializing in difficult-to-formulate products. The company maintains a rich pipeline entering 2005, and I forecast 100% revenue growth and a tripling in profits to $1 per share. At $15, the stock is cheap on my forecast. Just think where this would be if it was a tech stock. Who says value investing needs to be boring?

My tech turnaround theme remains a decent commitment. I've added a couple of new ideas to the portfolio in this sector, including Hewlett-Packard ( HPQ) and Quantum Corp. ( DSS).

H-P is simply too cheap not to own, with emerging fundamental improvements. The company also has a few non-operating tailwinds helping per-share profits, including favorable currency and a large share repurchase program.

Quantum Corp. is the potential home-run trade in the sector. The shares trade for an enterprise-to-revenue ratio of only 40%. The company has taken some aggressive steps to reduce operating expenses in order to meet its financial targets of 10% pretax profit margins.

With some exciting new storage-system products and new technology in the digital tape market, the turnaround should happen in 2005. Realizing its profit goals would generate about 40 cents in earnings per share and a stock much higher than $2.50. I've been premature in forecasting a recovery in the past for Quantum. It's time for CEO Rick Belluzzo to deliver the results befitting his resume and compensation package.

Trouble Spots

Now that you have some of my favorite long ideas, here is what concerns me about this market. I wrote something similar around this time last year: Most stocks are up, valuations are high and spreads have narrowed. Even ignoring the well-documented and significant fundamental imbalances in the global economy, it's hard to find shares that fit my new purchase model: down and cheap, with decent business conditions.

So I continue to expect modest returns from the equity markets, and I remain wary of many sectors in the market. I'd avoid much of the mega-cap part of the market, including most technology stocks, consumer durables, consumer staples, utilities, and energy and commodity cyclical stocks. Valuations appear far too high, and profit margins for many sectors are at peak levels. Some sectors might show low price/earnings ratios, but normalized profits are probably significantly below current levels.

After the sixth consecutive year of outperformance for the Russell 2000, small-cap and mid-cap stocks are even more expensive than their large-cap brethren. You can still find a cheap name here and there, but for the most part, the smaller part of the market has been picked over in this latest bull run. Small stocks tend to be more sensitive to changes in interest rates than large-cap stocks. And Fed Chairman Alan Greenspan has well advertised his intentions with rates.

As we finish a surprisingly good year for the stock market in 2004, enjoy its conclusion and remember that the whole year was made in two months after the election. Some analysts are speculating that 2005 could contain a powerful, 20%-ish bull run. This idea is intriguing; I might even give any first-half rally the benefit of the doubt.

When it's all said and done, though, I expect 2005 to be as challenging and frustrating as was most of 2004.

At the time of publication, Marcin was long WellPoint, Pulte, Impax Labs, Hewlett-Packard and Quantum Corp., 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.

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