In the five years since Sept. 11, 2001, financial markets have been characterized by manic extremes -- extreme caution and excessive risk-taking.

The 9/11 terrorist attacks and the fear that ensued prompted aggressive rate cuts by global central banks. The flood of liquidity was like a jolt of adrenaline to the markets. Once the panic and grief subsided, investors took their energy and cheap money to the all-you-can-eat risk buffet, looking for the next investment high, the best return and the most yield. At the same time, corporate America hoarded cash and rode profit margins up for one of the longest streaks of double-digit earnings growth in history.

"The market has really been inoculated against terrorism," says Woody Dorsey, president of Market Semiotics, a research firm that specializes in behavioral economics. "We know we're fighting a war on terror now, but we didn't know that on Sept. 10

2001. Traders say, 'We don't like it, but it would not stop us from buying.' "

As traders navigated the cheap-money waters in the wake of the attacks, the stock market proved admirably resilient given the magnitude of what happened -- the first attack on American soil since Pearl Harbor in 1941. After attempting to bottom a week or so after the attacks, the market rallied into January, then sold off again to eventually bottom in October 2002. Traders quickly got hip to the trend.

"Terror is bullish," wrote one trader in an email to clients the morning after the Mumbai train bombings on July 11. The trader, who declined to be named, echoed the same sentiment on Aug. 10, when U.K. authorities foiled a terrorist plot to blow up transatlantic flights. The major U.S. indices finished up on both of those days. Although London's stock market fell the morning of Aug. 10, even it was in the green by the end of the day.

In hindsight, the U.S. stock market's behavior when markets reopened on Sept. 17, 2001, did not stray far from normal patterns. "The event exacerbated the trading range process already underway," wrote Tobias Levkovich, chief U.S. equity strategist at Citigroup, in a note last year.

While 9/11 was the "spiked punch nobody expected," as Dorsey puts it, 9/11 wasn't a turning point in the market. It may have only postponed the bottoming process.

What traders knew on Sept. 10, 2001, was that the Internet bubble had burst, and the markets and the economy were in free fall. The day before 9/11, the

S&P 500

was down more than 15% from its spring 2001 rally, and 28.5% from its all-time high in March 2000. The

Dow Jones Industrial Average

had slid about 15% since May 2001, and 18% from its January 2000 all-time high. The

Nasdaq Composite

was already down 66% from its all-time high in March 2000, and down 27% from its more recent May 2001 peak.

"Everyone knew we were in a bubble," says Marc Pado, chief investment strategist at Cantor Fitzgerald. "There were huge upsides and huge downsides, and if you didn't play the game, you were just out of it."

Many market participants were already busy looking for the signs of a market bottom prior to 9/11. Signs of peak bearishness were taking shape. Sentiment signals such as the put/call ratio were climbing, and investors were weighing the likelihood of seasonal weakness in September.

"People were looking for a selling climax," says Pado, who joined Cantor Fitzgerald, whose home offices were located in one of the Twin Towers, several months after the 9/11 attacks. Prior to 9/11, many traders expected a double bottom in October 2001 and then again in March 2002. Instead, the market bottomed in October 2002.

After 9/11, many money mangers pointed to terror as a major risk to their portfolios. But should another attack occur on U.S. soil, "we would not assume that portfolios should be positioned defensively," writes Levkovich. "Instead we suggest that a shock to the system could be short-lived and that the fundamentals in place will remain relevant."

Indeed, small-cap stocks were the best performers in the post-9/11 era as the

Federal Reserve's

aggressive monetary policy encouraged risk-taking and trumped concerns about terror. In the past five years, the Russell 2000 is up nearly 60%, more than double the Nasdaq's gain and triple the advances of the S&P and Dow.

That said, Levkovich's research suggests that the U.S. stock market is more reactive to events on our home turf than to wars or terrorist events on foreign soil. And, of course, there have been no terror attacks in America since 9/11.

Still, "this is always with us," says Art Hogan, chief market analyst at Jefferies & Co., adding the possibility of a terror attack is priced into the market. Oil, in particular has a $10 per barrel premium priced in to reflect fears of supply disruptions due to terrorism, he says.

Indeed, the risk premiums on stocks are high as a result of 9/11, writes Bob Doll, president and chief investment officer at Merrill Lynch Investment Managers, noting that while corporate profits have been robust since the market bottomed in 2002, stock prices have not risen alongside earnings as much as most expected. "In our view, one of the factors contributing to lower P/E ratios is that there is a higher level of 'risk premium' built into stock prices," writes Doll. "Investors have become more uneasy about the future."

Indeed, the S&P 500's forward P/E of around 17 is low relative to rock-bottom Treasury yields -- more especially amid 12 quarters of double-digit corporate earnings growth, extensive balance sheet repair and record-setting corporate cash positions. This caution could be what's kept larger corrections and swings at bay for the markets throughout the past three and a half year bull market.

But if investors have became uneasy about stocks, risk premiums fell sharply in other asset classes after 9/11. For example, prices soared in high-yield bonds, emerging market debt, commodities and, most importantly, real estate.

Lulled by the security of physical assets, real estate became the speculative investment

du jour

. But real estate is not as liquid as stocks, so the boom-bust cycles are slower to materialize. As real estate and other recently popular asset classes come off the boil, some of that speculative money is likely to flow back into stocks, says Pado.

And the more time passes since 9/11, risk premiums in the stock market are likely to fade -- for better or for worse.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

here

to send her an email.