(MONEY Magazine) – The most important trend in the stock market today is what analysts call divergence. The best-performing stocks keep moving higher, while shares that have long been lagging fall further and further behind. Sometimes analysts describe this situation by saying that breadth is deteriorating. But it all boils down to the same thing: In the stock market (as in the country as a whole), the rich are getting richer while the poor are getting poorer.

This trend is sometimes a signal that a bull market is on its last legs. As individual stocks run out of steam, investors begin a flight to quality. They throw their money at a steadily dwindling number of blue-chip growth stocks that seem safe. Eventually, those are toppled too, swept away like the aristocrats of czarist Russia in a rising tide of misery. A crushing and protracted bear market often follows.

This may sound like a dismal possibility to ponder at a time when the market indexes are setting records--or at least are close to all-time highs. And while market divergence doesn't automatically trigger a slump, what is going on today is so extreme that attention must be paid. Just consider these facts:

A dozen of the largest U.S. companies account for virtually all of the increase in the S&P 500 this year. Subtract the gains of stocks like Cisco Systems and General Electric from the index, and the winners among the other 488 stocks are almost completely offset by the losers. In fact, as of mid-December more than half of the stocks in the S&P 500 were actually down for 1999.

The picture is even more extreme when you look at small companies. The Leuthold Group, a Minneapolis investment advisory firm, tracks 67 small Internet-related stocks. This Internet Insanity index, as president Steve Leuthold calls it, is up more than 125% in 1999 to 18 times sales. At the same time that these small tech stocks are skyrocketing, 52% of the stocks in the Nasdaq index are down for the year.

There's no law that says the extreme divergence going on today has to end in a stock market smashup. If, for example, the economy slows moderately over the next 12 months and inflation continues to remain low, Federal Reserve chairman Alan Greenspan would probably allow interest rates to decline. That, in turn, would give the market a lift across the board--and lagging stocks could catch up with the leaders. But prudent investors should recognize that the longer the current situation continues, the more volatile share prices will become. Any earnings disappointments or other unexpected bad news will wallop today's high fliers and make undervalued stocks even more depressed. The best defense is to manage down your risk with broad diversification. And when you do add stocks to your portfolio, look for companies with above-average growth and reasonable valuations. If you figure that the long-term return on the S&P 500 is 11% to 12% a year and the historical average price/earnings ratio is 16, your best bets will be stocks with at least 12% projected earnings growth and P/Es below 24 (1.5 times the historical average P/E).

Trimming risk in your portfolio. If, like most investors, you've put the largest chunk of your portfolio in blue-chip favorites (or in mutual funds that hold such shares), the recent outsize gains in those stocks will have made them an even bigger part of your overall holdings than you originally intended. If you've been thinking about selling any stocks in that category, this is a good time. If not, consider investing new money in other sectors that offer better value and broader diversification.

The greatest opportunities for long-term investors are in small- and midcap issues, which steadily lost ground from 1993 through early '99 but have stabilized in the past 12 months. At their peaks, small-caps can trade at P/Es 10% above those of the largest stocks. Currently, however, the P/Es of all but the hottest small stocks average less than half those of big stocks.

A rebound could take time. Historically, smaller stocks have needed as long as four years to recover from deeply undervalued levels. But if your time horizon is five years or longer, small- and midcap stocks look like an excellent bet.

Equally important, I would put some money into fixed-income investments. Treasury bonds, for instance, currently pay as much as 6.7%, while investment-grade preferred shares offer more than 8%. Leading junk bond funds can top 10% and some high-quality municipals are over 6% (equivalent to 8% or 9% for some top-tax-bracket investors).

Finding today's best stocks. The difficulty of picking stocks in a time of high divergence is that the most attractive companies with the best prospects are trading at such lofty prices. As a result, they would be extremely vulnerable in the event of a market setback. At the other extreme, the stocks that look most undervalued seem likely to stay that way. In fact, deeply depressed stocks are currently showing their worst relative performance in half a century.

I'm a conservative investor, and I especially like to look for companies with dominant positions in essential industries whose shares are trading at low P/Es because of temporary problems. But in this environment, I recognize that these troubled but cheap franchises may take a long time to pay off.

Here are two perfect examples.

I'm convinced that the railroads will thrive as industry consolidation produces stronger companies with greater geographical reach. However, the key merger--between Union Pacific and Southern Pacific in 1996--not only created the largest U.S. railroad, it also produced horrific traffic jams, particularly in Texas. The mess became so serious that the shares of the new Union Pacific have never been able to surpass their 1996 high of $74.50. At $44, just a couple of bucks above the '99 low, Union Pacific is cheap at less than 12 times estimated earnings for 2000, but the stock remains listless.

I thought I was going to be able to dance around Union Pacific's problems by buying Norfolk Southern instead. But that company is having trouble absorbing the Conrail assets it acquired in June, and its stock performance also has been dismal. I still think the quality rails are appealing long-term buys based on the value of their franchises, but somebody is going to have to wake me when something finally happens.

For similar reasons, I like Lockheed Martin. Defense spending is slated to rise in the U.S. (and quite possibly overseas as well), and Lockheed Martin is the industry's 800-pound gorilla. I've written about Lockheed in this column before, and since then the stock's performance has been lousy. The company merged with Martin Marietta in 1995. And now, nearly five years later, it's still having trouble getting its act together. The franchise value is there, but Lockheed continues to look like the Union Pacific of the defense industry.

In short, buying value today is a strategy that's going to take a long time to pay off. So what's the alternative if stocks with visible growth are expensive and risky? The best choice is what analysts call growth at a reasonable price--namely companies with 12%-plus projected earnings gains and P/Es no more than double their growth rate.

One good example is Sealed Air, a leading maker of packaging materials--most notably bubble wrap (hence the company's name). With annual sales of around $2.8 billion, Sealed Air can be considered a midcap stock. It also gets lumped with the chemicals or the container group, two sectors that don't exactly command high P/E multiples. Nonetheless, the company has a very appealing profile.

Since 1990, Sealed Air has soared from $5 a share to a high of $70, and has since pulled back to $47. The company isn't nearly as widely followed as Microsoft, for instance, but since October both Salomon Smith Barney and Morgan Stanley Dean Witter have upgraded the stock. Standard & Poor's also gives it a five-star rating in the mid-cap growth category.

The business is straightforward, but the numbers are pretty impressive. Sealed Air acquired the Cryovac specialty-packaging division of W.R. Grace in 1998, which has boosted cash flow and is allowing for some modest cost cutting. Excess cash is being used to buy back stock. All together, the company is projected to turn in 16%-plus annual earnings growth. At $47, however, the stock trades at less than 22 times this year's projected earnings, or less than 1.4 times its growth rate.

If that isn't enough to persuade you, then consider this. As e-commerce grows, so does the number of purchases being shipped. And all those items need some kind of packaging. That's right. Bubble wrap is an Internet play selling at a reasonable price. What more could you want nowadays?

Michael Sivy can be reached at sivy_on_stocks@moneymail.com.