In the waning days of 2004, this column predicted a difficult and bifurcated stock market for 2005. So far, this year has played out close to expectations.

In February, I maintained that in a year of extreme investing, good money could be made in super-high-growth companies such as Apple ( AAPL) or Google ( GOOG), as well as in super-cheap stocks like KB Home ( KBH) or Citigroup ( C). Well, three out of four ain't bad!

I also expected the cap-weighted indices as well as the so-called average stock to struggle. So far this year, the indices have ranged from up a little to down mid-single digits. No one has gotten rich buying and holding any diversified index fund. And I don't think the second half will be much better.

My deep-value investment discipline has generated solid, if not spectacular, returns so far this year. Holdings in the energy, managed care, homebuilding, technology and industrial sectors have provided strong returns. Most, if not all, of these names were highlighted in columns over the past 12 months.

On the downside, a few of the technology turnaround and value concept positions have disappointed. Also, my concern about difficult market conditions left me underinvested in many profitable holdings. A larger net long position would have been much better, despite the sloppy market. It feels as if investors, myself included, have made it much more difficult than it should have been.

My outlook for the market is more of the same. I am not heading-for-the-hills negative, but I believe that the next move is down. I am not selling my favorite longs but rather hedging them with short positions (and I always use buy-stop losses in the process). Should stocks correct, I could be enticed into becoming more normally invested, especially in cheap stocks that have dipped on decent fundamentals. By now, you should recognize my buy discipline.

But as I survey the investment landscape, beneath the sound bites and silly sell-side "blowout" labels, I am becoming more concerned about the equity market.

Don't Believe the Hype

Valuations are high, much higher than the financial press would have you believe. Market pundits quote an index multiple of 15 or 16 times profits. That's on next year's estimates. And it excludes all the "nonrecurring" bad stuff like charges and write-offs. And it includes a huge chunk of financials, a sector everyone hates, trading with price-to-earnings ratios of 10. Finally, it represents record profit margins.

What's the real P/E ratio of the average stock? Well, the value median P/E ratio is about 19 times 2005 profits. If one chooses to normalize profits, which are cyclical by the way, down to average margin levels, the P/E ratio rises into the low 20s. No matter how you slice it, even vs. unsustainably low interest rates, that's hardly bargain territory.

And that leads me to liquidity. Nominal economic growth continues to outpace money supply growth. The real economy should continue to drain liquidity from the financial sector. And Easy Al has shown no desire to temper the rate hikes. Ever since his deflation hoax and 1% wonder, he has been behind the curve. That's right, the deflation scare was a hoax, a cover to take short rates down to zero. It ignited the real estate bubble, and now the Fed has to fix this mess. Despite the pleas of numerous market commentators, the Fed continues to suggest multiple rate hikes for the rest of 2005.

Finally, investor sentiment remains quite complacent. Mutual fund cash levels are very low, and sentiment polls reveal an overwhelming bullish market opinion. Even a few very prominent perma-bearish talking heads have switched to the bullish camp recently. The bears/shorts have been beaten into such submission over the three-year monster bull market that CNBC struggles to find an opposing view to the bull case in various program segments.

In summary, my market exposure model indicators of valuation, liquidity and sentiment suggest caution. Also, we are entering a historically difficult seasonal period for shares. For whatever set of reasons, the fall season seems to house sharp corrections and mini bear markets. There is no reason for 2005 to be any different. This is the only time of the year that I give a conservative investment posture the benefit of the doubt.

Pigs Get Slaughtered

I think now is a good time to take some chips off the table. That's correct, sell stocks, "ring the register," to quote Cramer. We have experienced a wonderful bull market from three short years ago. For many stocks, especially small-cap shares, it has been a one-way ticket to Profitsville.

However, most of the factors that generated the bull stampede are maturing. Prudence dictates harvesting share gains into market rallies, especially into such an aged bull. Why sell now, into such good conditions? Stocks are up a lot. Valuations are fair to high. Rates are rising. Profit margins are peaking. Currency gains are vanishing. And virtually everyone is bullish. If you can't sell some now, when can you?

Could this call be wrong? Absolutely. Could the rally continue? Certainly. The market has a fair degree of momentum and goodwill. When investors want to believe that no revenue growth quarters from Broadcom ( BRCM) or Texas Instruments ( TXN) represent "blowouts," it's extremely difficult to call a short-term top. When 50 P/E Internet retailers spike on 2-cent earnings surprises, watch out above! When a formerly leading market strategist turns bullish after a decade-long affair with the bear, investors' glasses are a much deeper shade of red than rose.

Usually, my column contains at least a few deep value stocks I like, even when cautious on the market. And it's fair to say that I have not been a snorting bull over the past four quarters. But this time, my new-buy candidate list is unusually skimpy. Down, cheap, with good fundamentals is not easy to find. And if you review my record from prior columns, my long ideas tend to have high success rates. That's what happens when you buy stocks too cheap to be true. I just don't have many to offer here and now.

So, take some chips off the table. Blow them in Vegas in the poker bubble if you want. The odds might be better there for the next few months. Just leave some room to buy stocks if the fall correction comes back around this year. Remember, if you can't sell now...

At the time of publication, Marcin was long KB Home and Citigroup, although positions may change at any time.

Robert Marcin is the founder of Defiance Asset Management, a private investment management firm. Client accounts managed by Defiance Asset Management often buy and sell securities that are the subject of articles written by Mr. Marcin, both before and after the articles are posted. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide insight into the financial services industry and is not a solicitation of any kind. Neither Mr. Marcin nor Defiance Asset Management can provide investment advice or respond to individual requests for recommendations. However, Marcin appreciates your feedback; click here to send him an email. Mr. Marcin is not responsible to update any portion of this article in response to events that may transpire subsequent to its original publication date.

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