(FORTUNE Magazine) – Who would have guessed? Here we are facing renewed inflation, high interest rates, and recession worries, yet the stock market blossoms as if bad news were its favorite fertilizer. The rousing springtime rally pushed the Dow Jones industrials above 2400 for the first time in two years. Now the big question for most investors is whether to join the party or risk missing another bonanza. This market rally, for all its good vibes, is not worth chasing. While individuals should always have a portion of their wealth in stocks, the case for upping the ante now is not good. Stocks, after all, are getting expensive. By one highly respected yardstick, the dividend discount model, which measures the present value of future returns at current interest rates, the market is as much as 20% overvalued. That's well below the dangerous 40% overvaluation that prevailed prior to the 1987 crash, but it is reason for caution. Though the market has bucked high interest rates for a while, it cannot ignore that force for long. Says Steven Einhorn, chief investment strategist at Goldman Sachs: ''The long-term return from stocks is 10%. Any time you see the risk-free rate on short-term bonds approaching that number, it becomes a very attractive alternative.'' The rate on one-year Treasury notes has lately hovered just above 9%. Profit trends spell more trouble for stocks. According to the Institutional Brokers Estimate System, investment strategists expect earnings of companies in Standard & Poor's 500-stock index to grow 9% in 1989. That's down sharply from last year's 36% leap. Studies of previous market cycles reveal that stocks have a tough time sustaining a climb without a push from accelerating earnings gains. Earnings that do show up will be worth less to investors than in the past, for the quality of earnings has been falling. That's clear from the chart at left, which shows the ratio of industry's ''adjusted'' to reported profits. Adjusted profits include excess depreciation charges, if any, but leave out inflation-related inventory gains. What results is a far more realistic figure. Earnings quality took a jump in the mid-1980s when liberal tax laws allowed companies to charge rapid depreciation on plant and equipment, which depressed reported earnings while producing a bumper crop of surplus cash. But the 1986 Tax Act took away most of those benefits. Since they are not getting something extra for their money, says Hugh Johnson, chief investment officer at First Albany, investors may be reluctant to pay higher price/earnings multiples on the earnings they see. Lower-grade earnings could have negative consequences for the one big group of aggressive stock buyers these days: corporations caught up in the takeover and restructuring craze. These buyers want real cash profits, since that is what they use to pay down debt after a takeover or to buy back stock in a restructuring. All that said, the market could keep on climbing. That's because investors, big and small, are flush with cash. Usually, when the market rises both institutions and individuals empty their wallets to get the maximum ride. Not this time. Says Michael Sherman, chief strategist at Shearson Lehman Hutton: ''The market move was force-fed by corporate buying. Private pension funds, as well as individuals, have been sellers of stocks for some time.'' Sherman thinks that the market's recent climb could lure much of that pent- up cash and produce an encore. But as 1987 proved only too dramatically, the spectacle of rising prices alone is a poor reason to buy stocks. Unless the recent recovery in the bond market continues or something else improves the value of the market, another spurt in stock prices could quickly end in a steep slide. Despite the need for caution, some undervalued stock groups offer good value. Growth stocks, historically the market's most overpriced stuff, are now selling at mouthwateringly low premiums. One reason is that high interest rates penalize these stocks more than others by heavily discounting the value of far-off profits. Because growth companies are not big generators of surplus cash flow, most of their stocks have also been passed over by raiders. Einhorn at Goldman Sachs is steering his clients toward such companies as DUN & BRADSTREET and MERCK. Among the growth sector's most depressed companies are those in technology- related businesses. Over the four quarters ended in March, technology stocks returned only 5%, counting dividends, far below the total return of 18% on the S&P 500. That's nothing new. Technology stocks have been underperforming for many years. As a result, they're cheaper in relative terms than at any time in the last two decades. But because an individual company's fortunes are so unpredictable, don't try to pick the stocks on your own. Invest in a broad- based technology mutual fund like SCI/TECH HOLDINGS, run by Merrill Lynch Asset Management, or ALLIANCE TECHNOLOGY, run by Alliance Capital Management. Both are in New York. For the no-load crowd, Baltimore's T. Rowe Price has a new entry called the SCIENCE AND TECHNOLOGY FUND. Oddly at this advanced stage in the economic cycle, attractive stocks can be found in basic industry. These stocks have fallen from their highs out of fear that a recession would flatten their profits. But many companies in this sector have pared costs and are in good shape to weather a downturn. Sherman of Shearson, who likes copper producer PHELPS DODGE and nickel giant INCO, thinks the payoff to stockholders is just beginning. Inco paid out a special $10 dividend to shareholders in January, he says, and will soon be able to do it again. What follows is a guide to the other principal markets:

-- BONDS. The key word these days is patience. Despite the Federal Reserve's demonstration that it aims to rein in the economy by pushing up short-term interest rates, investor anxiety over inflation remains high. Those who buy bonds now could be in for more rough weather over the near term, but the longer-term gains should make the wait worthwhile. For example, if long-term bond rates rise a percentage point or so before declining again -- considered the worst possibility by most -- bonds are still a good deal. With 30-year Treasury bonds now yielding 8.9%, a one-point rise in rates would still leave the investor with a positive 4% return: The current yield would more than offset the 5% price decline prompted by the rate rise. If rates should fall by a percentage point, on the other hand, the payoff is a handsome 15% total return. Timothy Dalton, president of Dillon Read Capital, thinks the trade-off is a good one: ''Whenever the downside on an investment is a positive number, it gets our attention.'' Mortgage-backed securities, or bonds consisting of home mortgages that have been bundled together, are an especially attractive corner of the bond market. One big issuer of mortgage-backed securities, the Government National Mortgage Association, or Ginnie Mae, has a direct government guarantee behind its securities. Your money is safe even if some of the mortgages should default. Ginnie Maes currently yield 10.6%, a percentage point and a half over T-bonds of the same maturity, an unusually wide gap. Be warned, however, that Ginnie Maes may not perform as well as other bonds if interest rates should decline. That's because the mortgages that underlie these bonds can be prepaid if the homeowners wish to refinance at a lower rate, thus denying the Ginnie Mae holder a capital gain. To avoid this risk, James Kochan, chief bond strategist at Merrill Lynch, advises sticking to mortgage-backed securities with coupon rates under 10%, since they are less likely to be prepaid. Taxophobes will do best by buying municipals with ten- to 20-year maturities, which offer a much better yield relative to taxable bonds than shorter-term munis. Currently a 20-year municipal bond yields 7.25% on average, or 80% as much as a taxable Treasury bond. Those who remember back to 1985, when munis yielded 95% as much as Treasuries, may find the latest yield niggardly. But for an investor in the 28% tax bracket, the current yield on munis beats the after-tax yield on Treasuries, which is only 6.5%. This is a good time to upgrade municipal portfolios. The spread in yields between higher- and lower-quality securities is unusually thin, making it possible to trade in lower-quality bonds for better ones without forfeiting a lot of income. Thomas Spalding, who oversees Nuveen's $7.3 billion in municipal bond investments, recommends insured munis. Because these bonds are privately insured, their credit quality is triple-A. But the insurance wrinkle confuses some investors, so the bonds yield slightly more than conventional triple-A munis. It would be convenient in these uncertain times if convertible bonds, the ultimate device for straddling the fence, were fetchingly priced. Unfortunately, heavy demand from investors and a shrinking supply have pushed up prices of these bond-stock hybrids. Says Michael Vaughn, head of convertible bond sales at First Boston: ''Many companies think their stocks are underpriced, so they are redeeming the convertibles to avoid conversion into the stock.''

-- REAL ESTATE. The last time inflation heated up, rich yields and double- digit appreciation provided a splendid hedge. Because of vast commercial overbuilding during the 1980s, office vacancy rates in the nation's top cities are more than half again as high as five years ago. Many landlords can't raise rents. Given the risks, it is paramount that investors avoid high fees when buying bricks and mortar. The hefty fees of real estate limited partnerships can run as high as 20% of the amount invested. Real estate investment trusts, or REITs, are a better bet. These trusts are publicly traded and come with no front-end fees. Many offer enticing yields. Thanks to the Catastrophic Health Care Bill of 1988, prospects are brightening for some REITs that specialize in building and operating health care facilities for the elderly. The new law makes it easier for people to qualify for federally funded Medicare, which reimburses health care providers more generously than state-funded Medicaid. Burland East, an analyst at Alex. Brown, recommends HEALTHCARE PROPERTY INVESTORS, which is heavily invested in convalescent care facilities. The REIT currently yields a rosy-cheeked 11%.

-- COMMODITIES. Want to know what dry is? Try one of the many little towns in northern Iowa that are so parched there's talk of getting the U.S. Army to bring in truck caravans of H2O. All that cracked earth means higher prices, particularly for corn and soybeans, which are the chief crops in the driest areas. Analysts expect that corn prices will continue to trend upward, reflecting the tight supply. Soybean's bull run could be short-lived, however. Though U.S. supplies are tight, Joel Karlin, a grain analyst at Research Department Inc. in Chicago, says the foreign supply of beans will undercut the domestic price rally. ''Brazil is harvesting a monster crop,'' he says. The dry spell in Kansas bodes well for wheat prices. The state normally produces 20% of the nation's wheat crop, but analysts say this year's output should be down 50%. Overseas producers like China, Canada, and Argentina are also suffering drought and crop shortages. Karlin expects the price to reach $4.25 per bushel. In the precious metals arena, gold bugs can't seem to get excited about the inflation numbers. That's not surprising. Studies of past gold-price movements suggest that gold doesn't gleam in the market until inflation reaches 7% to 8%, far above the 5.5% that Fortune anticipates later this year. Palladium is rising on talk of a successful cold-water fusion process, which if commercialized would increase demand for the metal. Yet even if cold-water fusion works, the frenzy over palladium's prospects is premature since widespread use of the new technology would be a long time coming. The only cold-water process today's palladium buyers are likely to catch is a good dousing in the market.

BOX: WHAT THE HECK DO I DO NOW?

STOCKS -- Most look overvalued after the latest rally. But bargains remain, especially in growth and basic industries.

BONDS -- The prospects for capital gains look good, though bond prices could still suffer some. Ginnie Maes are cheap.

REAL ESTATE -- The good bets are mainly real estate investment trusts, especially those that own health care facilities.

COMMODITIES -- Inflation is still too low to spark a bull market in gold. Dry weather in the Midwest is pushing up grain prices.

CHART: NOT AVAILABLE CREDIT: SOURCE: DEPT. OF COMMERCE CAPTION: QUALITY OF EARNINGS A LEANER MIXTURE Profits adjusted to exclude inventory gains and to include excess depreciation reveal more than reported profits. The ratio of the former to the latter has slipped.