(FORTUNE Magazine) – To say that biotech is red-hot would be an understatement. It's blazing. Think surface of the sun, if you will. The Amex Biotech Index is up 260% over the past 52 weeks, dwarfing a 100% gain for the Nasdaq. Once-obscure researchers like Celera Genomics and Millennium Pharmaceuticals are actually becoming household names.

Far cry from the no-go '90s, when sector players like Kurt von Emster were as popular as vegans at a hog roast. Today von Emster is fighting off investors. His top-rated Franklin Biotechnology Discovery fund clocked a 98% return in 1999 and since January has seen assets balloon from $200 million to $1 billion. Last month he shut the doors to new blood. Marvels the manager: "It's like people have gotten religion."

But the question is, Has the "second coming" of biotech already come and gone? Though the stocks continue to rise at a torrid pace, warning signs are all over the road. For one thing, speculation is rampant, particularly among day traders and institutions that have turned their sights from e-tech to bio. They're bidding up anything with "gene" or "cell" in its name. Valuations are so stretched that you'd have to measure stocks in multiples of price-to-lab-mice just to make the numbers look sane. And things will only get sloppier as Wall Street offers investors some $200 million to $500 million in new biotech issues a day--the pattern of the past few months. That's great for investment bankers but lousy for those of us who hunt for scraps in the aftermarket.

And finally there's a little history lesson the Street wants us to forget. Back in 1991 biotech was the rage; the group surged 250% by the start of 1992. Stocks like Centocor and Synergen were as likely to be discussed at the water cooler as Yahoo and Amazon.com are today. Investors were certain we'd eradicate hereditary illnesses and eat really big vegetables that would stay fresh for months. It took just a handful of research letdowns to prick that bubble. Soon afterward Centocor fell from a perch of $54 to $7; Synergen dropped from $68 to $5. The group spent the rest of the decade warming the bench for Nasdaq's tech stars and were held up only as an example of how not to invest.

But if the red flags really are flying at full mast, no one seems to care. In November, FORTUNE picked a handful of stocks--Amgen, Genzyme, Biogen, and Vertex Pharmaceuticals--as long-term plays. Since then, the quartet is up 75% on average. Though pricey compared with the overall market, they're solid companies. What's odd, however, is the stratospheric rise of firms that aren't exactly bio's blue chips--those with only a few million shares floating, market values below $500 million, no earnings, and no product on the market.

So what do they have going for them? For one thing, a huge chat-room following. Online junkies first got excited in late November, when word spread that Celera was nearly done decoding the human genome--ahead of a government-sponsored project--and would soon be able to charge drugmakers for access to the database of life. Bingo! Celera rose from $42 to $150 in December. And recently, it even traded above $300. "Stocks are routinely going up 50% in a single day on no real news," says veteran researcher Evan Sturza.

Celera's run juiced up the sub-$500 million tier and gave chat rooms something to gab about. Professional investors who once moved quietly into promising investments now spend hours tracking online chatter in case day traders get a whiff of a core holding. Take what happened to Cell Pathways, a lab with a promising experimental treatment for precancerous polyps that now has a $1.2 billion market value despite no booked sales. It jumped from $10 to $60 this year as thousands of messages piled up on Yahoo. The danger is that the momentum on the downside will be as strong as on the upside. Bear in mind: Momentum traders ordinarily flee at the first hint of trouble. "There's going to be pain after this euphoria, and even guys like me who are doing good research will suffer," Sturza says.

Does that mean you're a sucker if you get into biotech? Not necessarily. The irony is that today's sector really is different from a decade ago. Fundamentals, for one thing, have never looked stronger. Among the 350 or so public companies, 40 are profitable, compared with less than a dozen a few years ago. Other reasons for optimism: 180 drugs are in late-stage clinical trials, the FDA is less bureaucratic about approving drugs, and a bunch of drugs have already made a major mark in treating non-Hodgkin's lymphoma and breast cancer. Those successes also lured in big pharmaceuticals like Merck and Pfizer, which need biotech alliances or acquisitions to shore up their own positions before key patents expire. (For more on the sector's bright future, see "Blessings From the Book of Life.")

Many of the hottest companies will become huge financial successes. But as an investor, you need to question how far the rally can go. Aside from making some comparatively conservative bets on Biogen or Amgen--or perhaps buying Pfizer at 33 times forward earnings as a value play--you might be better off waiting for a correction. Let the momentum players get scared off. Then step in and buy companies with products either on the market or in late-stage trials. If you want more diversity, consider either a fund or buying shares of Merrill Lynch's Biotech "Holdr" (BBH), a single security representing an undivided interest in the 20 largest companies. It's up 94% since its inception in November. Hey, as one manager says, "In this type of market the only way to lose money is to sell too early." We'll see.