Is Wall Street taking out mortgages on castles in the air?

The past month has witnessed a powerful run-up in the major indices in the face of a mean season for the first quarter, when

S&P 500 earnings fell 6.9% on average. Since March 30, the last trading day of the first quarter, the

Dow Jones Industrial Average is up 10.1% and the

Nasdaq Composite Index has jumped 20.7% through Wednesday's close. But the market rally wasn't spurred by the dismal first period of 2001, but rather by a coalescing consensus that earnings would turn a corner a few quarters down the road.

The optimism is, in part, warranted: Recent studies indicate that stock bottoms typically precede earnings bottoms by about three-quarters of a year, and that markets historically do well during lousy earnings seasons. However, many Wall Streeters are worried that the rally has gotten ahead of itself, saying the earnings outlook is far from crystal clear, and stock valuations still aren't at bargain-basement levels.

"Investors came to the decision that first-quarter earnings were the worst they'll be and that they're in the process of bottoming," said Thomas Van Leuven, market strategist at

J.P. Morgan

. "But that's far from clear. The market's reaction was overstated."

Know Your History

In a recent study,

Ned Davis Research

examined eight cases since World War II when stock prices led earnings troughs. The research firm found that the S&P 500 on average bottomed 9.6 months before the trough in reported earnings, with a range of four to 15 months. For the current situation to chart a similar course, companies will need to get their acts -- and earnings -- together by about the end of this year.

Will America's finest come through? Indicators say yes -- and no. Earnings tracker

Thomson Financial/First Call

is predicting that earnings growth will remain negative until -- you guessed it -- the fourth quarter of this year. But that estimate is highly subject to revision. Consider: As recently as December, the prediction for earnings growth in the first quarter of 2001 on the S&P was a positive 5.1%.

What's more, a look at individual company reports paints an even cloudier picture. In the tech arena, growth stalwarts such as

Cisco Systems

(CSCO) - Get Report

,

Sun Microsystems

(SUNW) - Get Report

and

Intel

(INTC) - Get Report

have ramped down earnings and revenue growth expectations. But the stocks are up 26.5%, 33% and 21.4%, respectively, since the end of the first quarter.

Back in the Tech Game

For the March quarter, earnings growth for technology stocks, as gauged by the

S&P Technology Index

, declined 38% on a year-over-year basis. But the measure's market performance has surged 21.8% since the end of the first quarter.

Signs of an economic recovery, heightened by the

Federal Reserve's surprise intermeeting rate cut in April, encouraged investors to jump back into riskier positions -- which they did, despite fundamentals.

The S&P Healthcare Index

, which represents an economically safe basket of stocks, reported 15% earnings growth in the first quarter. But it's up only 1.9% since the beginning of April. Similarly, the

S&P Energy Index

showed 74% earnings growth, but it's up only 5.7% since the end of the quarter.

It's clear that investors are by and large betting on a recovery, and a large portion of them are placing their bets on tech. But some experts say that's a risky wager. "We'd rather go with areas of the market that aren't economically sensitive," said Van Leuven. "We think that the performance by

technology was unjustified."

As far as technology goes, "the market is looking to the first quarter of next year," said Joseph Kalinowski, market strategist at Thomson Financial/First Call. "Stock prices have already discounted four full quarters of negative comparisons."

What Price Recovery?

But, valuations are still high. "The last time we had a bull market begin with a price-to-earnings multiple for the S&P at 23.5 was 1962," said Stanley Nabi, managing director at

Credit Suisse Asset Management

. "And that lasted only for a couple of weeks." Historically, the average P/E multiple for the broader market index is 15.

Nabi, for one, expects the sigh of relief that has taken the averages to recent highs to climb only another 2% or 3%. "In a couple of weeks, we'll begin to retrace," he said. "And we could successfully test the lows of March."

Other experts are more optimistic. "Negative earnings growth tends to be when the market does well," said Tim Hayes, chief market strategist for Ned Davis Research. "Since 1927, the market's been up 17% per annum in years where earnings growth on a year-over-year basis has been between 0 and negative 25%."

The year-over-year comparisons are going to get easier. But only time will tell if history repeats itself.