How much farther can this overvalued bull market run on fumes? Investors are about to find out the hard way. Animal spirits increasingly supplant rational justifications for higher share prices.

For now, the bulls hold sway. All three major indices soared on Thursday, with the Nasdaq hitting an all-time high. They were mostly powered by positive operating results from blue chips. Health services and retail were the leading sectors; the worst performers were consumer non-durables and energy.

But risks remain. Unlike the broad based rally of October, fewer stocks and sectors have been generating gains in November. Wednesday’s sharp declines marked the biggest one-day percentage drop for both the Dow Jones Industrial Average and the S&P 500 since September.

Bad breadth is a red flag. A sign of a market peak is when fewer stocks are participating in the upswing. It means that the major indices are lurching toward their final climax.

Bull runs often are propelled by a small number of “market leaders.” When these stocks falter, it could mean the rest of the troops will follow. Notwithstanding Thursday’s bull run, the market leaders such as tech and bank stocks have been losing steam in November.

Individual stocks typically march in lockstep with the market. This hasn’t been the case in November. This dynamic is a boon for proactive stick pickers. But it’s a warning bell when valuations are at historical extremes. Price-to-earnings ratios, dividend yields, and book values are off the charts.

The average bull market since World War II has lasted just 52 months. The current bull market, which started in April 2009, is approaching its ninth year.

The risks behind the rise…

On Thursday, the House passed a tax cut bill. But opposition is mounting in the Senate.

Analysts also are expressing concern over China. The Middle Kingdom is saddled with slowing growth as well as massive debt.

China announced on Thursday that it would cancel several infrastructure projects to get a grip on debt.

Recent estimates peg China’s troubled credit in excess of $5 trillion, which represents approximately half of the country’s annual gross domestic product. The policy makers in China’s centralized economy racked up this staggering debt by trying to stimulate the flagging economy. They relied on infrastructure projects, many of them wasteful.

China is now littered with bridges to nowhere and empty “see through” skyscrapers. The state also has pumped money into weak corporations that couldn’t survive without massive subsidies. These domestic loans are souring at an alarming rate.

China’s lenders also scoured the developing world for new borrowers. Part of their goal is to gain strategic leverage in regions neglected by the West. Several countries in Africa, Asia and Latin America are deeply in hock to Chinese banks. Many of these loans are becoming toxic, too.

So you can’t be blamed for getting worried. But you should be blamed if you run for the hills. In the context of recent uncertainty, you face three scenarios.

You can flee to safety and receive dismal returns. You can do nothing and get slaughtered. Or you take measures to simultaneously hedge your portfolio and profit.

Typically, the smart advice is to sit tight and ride out the storm. That still holds true, for the more resilient stocks in your portfolio. But in extreme circumstances as we’re witnessing today, it’s better to jettison the weakest stocks in the weakest sectors. Don’t ride the decline to the bottom.

Take a deep breath. Remember that weakness in the overall market isn’t sufficient reason to dump inherently strong stocks. Markets rise and fall, but over the long run a well-diversified portfolio provides the best gains.

And if you’re long growth stocks, you probably had a very good day on Thursday. Let’s do the numbers.

Thursday Market Wrap

• DJIA +0.80% or +187.08 points, to close at 23,458.36
  
• S&P 500 +0.82% or +21.02 points, to close at 2,585.64
  
• Nasdaq +1.30% or +87.08 points, to close at 6,793.29
  

Thursday’s Big Gainers

• NetApp (NSDQ: NTAP) +15.91%

Data storage firm jumps after strong fiscal 2Q earnings.

• Wal-Mart (NYSE: WMT) +10.92%

Retailer’s 3Q earnings crush Wall Street’s expectations.

• Cisco (NSDQ: CSCO) +5.19%

Tech giant blows away 3Q expectations.

Thursday’s Big Losers

• Viacom (NSDQ: VIAB) -3.74%

Media firm issues weak expectations for distribution revenue.

• Best Buy (NYSE: BBY) -3.43%

Retailer’s guidance falls below expectations.

• Travelers (NYSE: TRV) -2.14%

Insurance carrier issues weak 3Q report card.

Letters to the Editor

“What kind of bond funds should I buy?”— Cynthia P.

Bonds are supposed to provide ballast for a portfolio during rough stock market seas, but as interest rates rise, investors such as Cynthia are unsure about bonds.

Although bonds are less risky than stocks, that doesn’t mean they aren’t risky at all. Investors need to account for several different kinds of risk when they evaluate bonds. The worst risks are default risk and interest rate risk.

Default risk accounts for the chance that a company or government will simply stop paying their debts. That means the bondholder won’t get all the interest and/or principle he’s entitled to.

Interest rate risk accounts for the chance that rates will increase, making your bonds less valuable.

Your portfolio needs the safety of bonds. Not all bonds get crushed when the Federal Reserve tightens. Short-term bonds are less vulnerable to interest rates than longer-term bonds.

Got a question? Drop me a line: mailbag@investingdaily.com.

John Persinos is managing editor of Personal Finance and chief investment strategist of Breakthrough Tech Profits.