HOW TO SURVIVE AN OVERHEATED MARKET

By Daniel Kadlec

The stock market has officially entered La-La Land. The summer rally that last week pushed the Dow Jones industrial average to within a whisker of 8000 has blown through the last remaining bounds of sanity. No sweat, say some Wall Street swamis. The market has a permanent visa to the ether. But don't believe it. Like Wile E. Coyote running off a cliff while chasing the Roadrunner, the market is churning its legs furiously, but there's nothing beneath it. When investors finally look down...

Yes, you've heard such naysaying before. This mighty bull market long ago trampled traditional value measures such as stock prices relative to corporate assets and dividends. Investors--correctly, it turns out--laughed off the notion that the market must weaken just because dividend yields (annual dividend divided by stock price) sank to below 2% when they've rarely been below 3% any time this century. They also laughed off gobs of anecdotal evidence that prices were precariously high: cab drivers offering mutual-fund tips, barbershops tuned to CNBC, record prices for seats on the New York Stock Exchange, exploding margin debt and the proliferation of investment clubs across the country.

But ultimately it may be tougher to shrug off some of this year's developments. Start with the recent rally, which has taken the Standard & Poor's 500 to a gain of 21% through the first half of the year. That follows gains of 23% last year and 37% in 1995. In this century there have never been three consecutive years where the Dow rose more than 20% each year.

Even if such long odds don't faze you, consider the latest warning shot: stratospheric P/E ratios. Stock prices relative to earnings are the highest they have ever been, according to the research firm I.B.E.S. The average stock trades at nearly 19 times its projected earnings per share over the next 12 months. The previous high was 17, in the early 1960s, a period much like today: low inflation, low interest rates, strong profits. Coca-Cola, to name one, trades at 36 times the earnings Wall Street expects it to enjoy in 1998. Coke is a great company. But for that kind of price its secret formula should cure a lot more than a thirst. Such lofty PEs are more troubling than other market flashpoints because they are based on earnings, which are the market's lifeblood.

So what's an investor to do? Take note, for one thing. You may find some bargains out there, but on average if you buy stocks today, you are paying more than anyone in the history of commerce to get into the market. That's what Alan Greenspan, Warren Buffett, George Soros and others have been suggesting for months. And that is why some of Wall Street's top strategists are lightening up on stocks. Barton Biggs at Morgan Stanley Dean Witter opens his newest report with the line "I am raising more cash." It doesn't mean a crash is imminent or even inevitable. But the current pace cannot continue, and it is increasingly likely that a big dip is coming--one that won't be followed by a quick recovery.

The most important thing to manage now is your own expectations, bearing in mind that stocks should return about 11% a year and that every year of outsize gains raises the odds for one of subpar gains and even occasional losses. Here are some other tips for dealing with a soaring market:

--Don't get greedy. If you've been in the market the past three years, you've been handed a bonanza. You may have reached financial goals (college, vacation house) you didn't expect to hit for five more years. Cash in some chips now, especially if you're over 60 or can sell without tax consequences, as in a tax-deferred account.

--Don't be naive. This is no time to plunk down a huge lump sum. If you've got money and you're bent on investing it in stocks, do so slowly over, say, 12 months to lower the odds of a big dip occurring right after you invest your wad. And don't buy stocks that are sky-high. Eric Miller, chief strategist at Donaldson Lufkin & Jenrette, likes Wells Fargo, El Paso Electric and Chubb. David Shulman, chief strategist at Salomon Bros., likes Home Depot, Maytag and Hilton Hotels.

--Don't be really naive. No matter what, you shouldn't sell everything hoping to buy cheaper later on. All-or-nothing market bets rarely work. Especially if you're under 60, leave the bulk of your investments in stocks for the long term. But consider raising a cash cushion to buy stocks after a decline.

--Rebalance. Your blue-chip stocks could be up 50% since you last checked. If so, you may have a greater weighting in stocks relative to bonds and in big stocks relative to little stocks than you ever intended. Sell some blue chips to buy bonds, small stocks and foreign stocks.

Any changes might haunt you if stocks go a lot higher. But the same is true of what you don't change if they fall. And my bet is that there are no permanent passes in La-La Land.

Daniel Kadlec can be reached online at kadlec@time.com