STOCKS ARE NEARING THE DANGER ZONE
By Michael Sivy Senior editor Michael Sivy is a chartered financial analyst and a former director of research on Wall Street.

(MONEY Magazine) – As the Dow industrials busted through the 2900 mark and went on to record highs, small investors rediscovered their enthusiasm for stocks. In April, total cash flowing into equity mutual funds (after redemptions) amounted to more than $3 billion. And many leading mutual fund companies say that new money gushed into their stock funds even faster in May. It's nice to be bullish on America, but will this stock spree really pay off? It will -- but only in the short run. There's no question that the market is on a roll, and here's why: -- Inflation, which seemed to be bucking out of control only three months ago, is now widely regarded as tamed. -- Interest rates have dropped half a point in the past six weeks. -- And analysts have been raising earnings estimates on stocks they cover. So how high can the market go? Pick a number. Or if you want to be a little more scientific (but just a bit), consider that the yield on the Dow has sometimes gotten as low as 3% or even a smidgen less at stock market peaks. With the Dow's current dividend, that works out to a top of 3300. To anyone over eight years of age who can remember an 800 Dow, 3300 sounds mind-boggling. From where we are now, though, it's only a little over 10% away, and there's no guarantee that the market will make it there. It's true that inflation is under control, but in part that's because companies aren't passing on all their costs to customers. As a result, despite . many analysts' optimism, corporate profit margins are under increasing pressure. It's also true that interest rates are likely to keep falling. Last month, we forecast that yields on long-term Treasuries, then at 8.9%, would drop to 8.25% by early next year. With rates down to 8.4% already, our target looks conservative. But there's a catch: rates are declining primarily because the economy is slowing. The stock market is rising on weakness, not on strength. Analysts who are pumping up their earnings estimates seem to be reworking their computer spreadsheets because results for the tough first quarter held up better than they expected. Rays of hope in, sunbursts of profit out. But if the economy continues to darken, many of their estimates could be all wet six months from now. The plain fact is that the stock market is entering the danger zone. It isn't time yet to sell every share you own (though one respected newsletter writer recently recommended just that), but the outlook for stock market profits over the next five years or so is getting dimmer. As we've mentioned before, historically when stocks have been at today's high levels, they return an average of only 6% to 7% annually over the next 10 years. In the book excerpt on page 100, Princeton University economics professor Burton G. Malkiel is more optimistic; he projects a 9.5% annual return for stocks in the 1990s. Still, he concludes that high-quality bonds, now yielding as much as 9.5%, are likely to be a better investment than stocks after you compare the risks. The biggest threat to stocks is the possibility of a recession. And we'll have one sooner or later. If the slowdown came now, for example, stocks could easily drop below 2500 -- conceivably quite a bit below -- giving you a loss of 15% or more to make up. Rather than regarding a further market advance as your last chance to get on the 4000 express, consider it a chance to sell. Although a well-diversified portfolio will always include some stocks, there's nothing wrong with cutting equities back to 25% of your overall investments. Keep another 25% of your money in cash, and increase high-quality bonds to as much as half of your portfolio. And if it's just driving you crazy to watch the stock market surge while you have money sitting in a bank, go buy a nice high-quality electric utility with a yield of 6% to 7%. It should do about as well as top-grade bonds.

BOX: -- The economy Growth has perked up, but it won't get much better. Inflation will stay in the 4.5% to 5% range or go lower. While a recession doesn't seem likely in the next three months, it remains a distinct possibility over the next three years. -- Stocks Stocks are becoming overvalued. During the next five years or longer, stocks are unlikely to outperform bonds when you compare the risks. In a recession, stocks could drop 15% or more, while bonds would hold their own. -- Bonds Long-term interest rates will continue to decline but not in a straight line. Expect some ups and downs. Still, Treasury yields could fall below 8.25% by early next year. Utility shares remain an attractive alternative to bonds.