Bond traders are brainier than stock traders, according to old Wall Street wisdom. After all, the bond market often signals in advance which way the stock market will head. In the summer of 2007, for example, bond investors started flocking to safe, conservative risk-free U.S.-issued debt even as the Dow Jones Industrial Average kept climbing toward its record October high (We all know what eventually happened.) Two and a half years later, the bond market is totally over the credit crisis. As of last week, the difference in yield between highly-rated corporate bonds and 30-year U.S. Treasurys a key measure of investors perception of risk had narrowed to its lowest levels since July 2007, according to Bespoke Investment Group, a money management and research firm.

Stocks, meanwhile, aren t even close to their July 2007 levels. The S&P 500 index closed at 1145 on Wednesday, well below its peak of 1565 in October 2007. We probably have a ways to go in the stock market, says Jim Swanson, chief investment strategist for MFS Investment Management. In other words, those concerned that the stock market s running out of steam after its 68% rally since last March might consider listening to the bond market. A company s ability to repay its debt depends on its cash flow and earnings, factors that also influence its stock price. Bond investors must correctly assess a company s ability to honor its debt obligations, since they could wind up with zero if the company defaults, Swanson says. A bond also lacks the potential upside of stocks, he notes, putting a greater onus on bond investors to get it right.

Plenty of stock investors do pay attention to the bond market. Keith Goddard, co-manager of the Capital Advisors Growth Fund, regularly looks at the difference in yield between high-yielding, low-quality junk bonds and the 10-year Treasury. His firm has tracked the data back to 1986. When the yield spread, as it s called, goes beyond 6.8 percentage points (historically a huge spread), he tilts his portfolio toward more conservative names like Wal-Mart (WMT) . Alan Gayle, director of asset allocation for RidgeWorth Investments, looks at another key bond market indicator, Libor (the interest rate at which banks lend to other banks), to gauge how the bond market s functioning. After all, when lending freezes up, companies can t invest in their businesses or, in extreme cases, even meet payroll.

How can investors at home play their own market sentiment? Investors who are bullish on the stock market might consider adding technology and manufacturing names to their portfolios, since these sectors generally respond well to revived business and consumer spending, says Bernie McSherry, senior vice president of Cuttone & Compay, an institutional brokerage on the floor of the New York Stock Exchange. Most professional traders will also hedge their bets in case they re wrong, and the bulls could do this by shorting stocks in sectors they think will soon fall out of favor, he says. Bearish investors might consider shorting real estate and banking names, since they think high unemployment will continue to weigh on those sectors, McSherry says.