We continue to believe the five-year global bull market is ending and risk assets offer a very poor risk-reward as interest rates, profit margins and valuation levels are poised to "regress to the mean."

In our view, the liquidity created by six years of the Federal Reserve buying bonds (Quantitative Easing, or QE) has caused financial markets to decouple from the real economy, while driving equities to a historic level of overvaluation. As discussed in our Q2 market letter, we expect a significant correction (15% or more) as the Fed ends its QE program and no longer provides excess liquidity to support overvalued financial assets and dampen volatility.

While the Dow Jones Industrial Average, the S&P 500 and the NASDAQ Composite reached all-time highs on September 19th, the Russell 2000 again failed to confirm these new highs in the major averages. As discussed previously, we believe this divergence (now six months old) is a significant sign that investors are becoming risk averse and the markets may be vulnerable in the near future.

For most of 2014, we recommended investors decrease their equity exposure and increase their safe asset exposure (government bonds, gold) until equities offered a more favorable risk-reward. While the financial media and pundits ridicule the bears for "missing out", as they celebrate each marginal all-time high, we believe a cautious outlook has been justified and that investors have not been adequately rewarded for assuming equity risk. In fact, most asset classes have similar year-to-date returns, despite significantly different risk profiles.

Overweighting safe assets has paid off this year, especially on a risk-adjusted basis.

In addition to the end of QE and the divergence between large and small cap stocks, our top-down outlook

remains cautious due to the following factors:

• Long-term valuation measures indicate stocks are overvalued by at least 30%
• Historically high profit margins are poised to regress to the mean and yield disappointing earnings
• The economy and normalized profit growth will remain sluggish, due to excessive debt levels, weak real
• wage growth and significant under-employment
• Weak or recessionary global economies and unstable currencies (Europe, Japan and China)
• Geopolitical risks (Middle East, Ukraine and Hong Kong)
• Many investors are too optimistic and complacent

The best way to compound wealth over time is to avoid major losses. For most of the year, our belief that the current market cycle was mature and stocks offered an inadequate risk-reward led us to reduce our equity exposure, and increase our asset diversification and balance. Recently, the nearing end of QE, the unfavorable seasonality and deteriorating market breadth led us to further reduce our risk exposure. We have used recent market strength to increase our long bond exposure, hedge some equity exposure with the Russell 2000 and initiate a short position in the high yield market.

Our asset allocation is defensive and focused on capital preservation:

Market Commentary: While the stock market's strength and lack of volatility--due to the excess liquidity provided by the Fed buying bonds (QE program)--have convinced many investors and market commentators that risks are diminished and the economy is accelerating, we expect stocks will correct and valuations will regress to the mean as the rate of liquidity growth declines and the economy continues to disappoint ebullient expectations.

Over the long term (7 to 10 years), market valuations and corporate profit margins will regress to the mean.

Fundamentals are cyclical because high returns on invested capital attract investment, which leads to increases in capacity and competition, which, in turn, lead to lower profit margins, disappointing earnings and lower stock valuations.

As the market cycle matures, valuations and profit margins become stretched, which leads to lower prospective returns while the risks increase, offering an unsatisfactory risk-reward. Unfortunately, most investors think in a linear manner and extrapolate today's success (high profitability and valuation levels) into the future. This procyclical tendency leads investors to have the most equity exposure at the end of a bull market and the least exposure at the beginning (buy high, sell low).

Currently, the market's valuation is extreme -- only the year 2000 bubble was greater -- while profit margins have never been higher. In our view, stocks offer a very poor risk-reward and are positioned to give significantly below-average returns over the intermediate term as the fundamentals return to normal levels.

Stocks are 49% overvalued based on market value to GDP

Larger Image - (Source:VectorGrader)

Stocks are 38% overvalued based on market value to replacement value

Larger Image - (Source: VectorGrader)

Stocks are 37% overvalued based on market value to cylically adjusted earnings

Larger Image - (Source: VectorGrader)

Profits at 10.6% of GDP are 2.5 standard deviations above its 65-year average of 6.46%

(Source: FRED)

While we believe, based on long-term valuation models, the market is poised to provide disappointing real returns of less than 4% versus a historic real return of 6.5% over the long term (7 to 10 years), recent signs of investors becoming more risk-averse lead us to believe a correction is imminent.

As discussed previously, the Russell 2000 has not achieved a new high since March, setting up a six-month divergence with the large-cap indices. Also, while the NASDAQ Composite reached an all-time high this month, its internal breadth has been weak since April. Currently, only 38.5% of the stocks in the index were above their 200-day moving average (61.5% of NASDAQ stocks are in a technical bear market). Historically, small-cap divergence, poor breadth and weak relative strength in secondary stocks have been a reliable signal that investors' risk preferences are changing, which typically leads to market corrections. The Russell 2000 has diverged and shown poor relative strength for 6 months

Larger Image - (Source: StockCharts.com)

Most Nasdaq stocks have been below their 200-day moving average since April

Larger Image - (Source: StockCharts.com)

Finally, the high yield market also shows signs of investors becoming more risk-averse. Bearing this out, high yield bond spreads have increased by more than 100 basis points (3.4% to 4.5%) in the last three months:

High-yield spreads are rising sharply

(Source: FRED)

In addition to investors becoming more risk averse, the significant divergence between large and small-cap stocks may be partially explained by the growth in corporate buybacks ($338 billion in the first half of the year).

Many large-cap companies with significant cash flow and/or access to record low-cost debt have bought in massive amounts of stock this year. According to Barclays, 31% of corporate cash flow was spent on buying back stock. While many believe this is a sign of confidence, we believe it is another consequence of the Fed's monetary experiment. Corporations, when faced with a dismal economy -- that has averaged less than 4% nominal GDP since the Great Recession -- and artificially low interest rates engineered by the Fed, decide to buy back stock instead of invest capital in the business or hire more employees.

Buybacks make sense when stocks are inexpensive, but with current valuations and profit margins at the other extreme, we believe the short-term decision to artificially boost earnings per share and stock prices will hurt the long-term prospects of many firms, especially those that borrowed to buy back their shares.

While buybacks have certainly contributed to increased stock prices over the past few years, in the future, the stock market will be vulnerable if current buyback levels are not maintained. Unfortunately, when profit margins normalize, as we expect, the current level of stock buybacks will not be maintained.

Economic Outlook: While many economists celebrate the strong Q2 GDP (ignoring the weak Q1), and extrapolate the sequential improvement into the future, we would point out that, on a year-over-year basis, the economy has shown no improvement and continues to muddle along, growing at a disappointing 2.5%.

While many strategists remain optimistic and expect the economy to finally reach escape velocity next year, we have several economic concerns. First, after massive increases in government debt, unprecedented growth in the Fed's balance sheet (printing money), and nearly six years of economic expansion, structural imbalances (that cause economic headwinds) have not been addressed.

Also, the yield curve, which is one of the best indicators of economic health, has been flattening all year. This indicator is not consistent with the bullish expectation of a sharp economic acceleration into next year.

(Source: FRED)

Finally, while our economy struggles to grow 2.5%, it appears the global economy has recently slowed and, after years of fighting deflation, many of our trading partners are in or near recession. We are concerned that the global economic weakness and deflationary pressure have the potential to push us back into recession. Europe and Japan have made it clear they will drive their currencies lower to "help" their economies recover. In our view, these weak currency policies will not help their economies, but will export deflation to the U.S. by artificially strengthening the dollar. Signs of deflation are already appearing in inflation expectations, gold and commodities.

Global weakness has driven the dollar sharply higher

(Source: FRED)

Inflation expectations have fallen

(Source: FRED)

Gold and commodities have declined sharply

Larger Image - (Source: StockCharts.com)

Larger Image - (Source: StockCharts.com)

In conclusion

While the stock market has not had a 10% correction in over three years, we believe the recent technical deterioration in the small, secondary stocks, coupled with the decreased level of liquidity in the market (due to end of QE), will lead to a significant correction this fall. Whether or not this correction becomes a bear market will depend on how our economy adapts to declining asset prices. We are concerned that overvalued markets, combined with excessive leverage and complacent investors, will lead to greater-than-expected volatility and may negatively affect already weak global economies fighting deflationary pressures.

As value investors, our core philosophy is that the best way to grow wealth is to have a long-term investment horizon and avoid major losses. Because profitability levels and growth regress to the mean over time, valuation is the best measure of long-run prospective returns. Currently, the equity markets are overvalued and offer a very poor risk-reward. We believe investors should reduce their exposure to risky assets and be patient until the risk-reward improves and investors are adequately rewarded for assuming equity risk. Historically, liquidity-driven bull markets deflate quickly and patient investors will be rewarded with great values and significant long-term opportunities.