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			» Six strategies for investing now

The ongoing conflicts in the Middle East, the recall election circus in California, and even the fur flying between Al Franken and Bill O'Reilly may lead the news from one evening to the next. But no topic more consistently claws for our attention right now than the fate of the economy and the markets. It's not that the recent news has been bad -- just damn confusing. The bond bubble has burst. Stocks have been racing ahead, further and faster, perhaps, than rational exuberance would suggest. Or heck, maybe it is rational. That's the problem: Who knows? For many of us, confusion has reached the point of urgency. And what we are left with are gnawing questions:

Will the floor fall out—once again—from the stock market? Is it too late to get in? If I hesitate, will I miss out on a monster rally? Should I bounce those bonds from my portfolio? Where on earth do I put my money? Er ... help.

Consider what's already been happening in the market: In the quarter ended June 30, a full 469 of the 500 stocks in S&P's large-cap index were up. The Dow Jones industrial average and the Russell 2000 small-cap index closed up for the sixth straight month in August; for Nasdaq, the streak hit seven, bringing the tech-heavy index to a 16-month high.

Investors have been pouring their money into stocks as though they had a hot tip at the track: $37.5 billion flowed into equity funds in June and July, according to AMG Data Services. (In the same two months last year, $52 billion was yanked out.) Wall Street firms are upping their equity allocations across the board; money managers are feverishly putting excess cash to work as the much-promised corporate profit rebound seems to have finally arrived. Earnings for the second quarter were far more robust than consensus estimates had forecast, even if they were boosted by the falling dollar and other nonoperating factors.

So far in 2003, reported earnings for S&P 500 companies have beaten analysts' first-quarter predictions by 6.1 percent and second-quarter projections by 5.9 percent, according to Thomson First Call. That's twice the normal rate of outperformance and the biggest margin recorded since Thomson began tracking estimates nine years ago. More than three-quarters of the companies in the S&P 500 reported growing revenues—with four of every ten boosting their top line by double digits, according to Glenmede Investment Research.

The signs of recovery are tantalizing. Every other day seems to bring new positive news about the economy -- orders for durable and capital goods are rising, inventories are shrinking, freight shipping and consumer confidence are spiking, and even housing indicators remain remarkably strong despite a rise in mortgage rates. There's talk of splashy dot-com IPOs again, and day traders, and QQQs, and Internet "sure things." What does it all add up to? "Unequivocally, we are in the early stages of a classic bull market," says Allen Sinai, president of Decision Economics in New York. "What is emerging now is a significant business cycle upturn of three years or so duration."

But also at play is something else -- something thoroughly uneconomic. A new investor fear has emerged: that of being left behind. "Investors now aren't exuberant —- they're annoyed," says Yale professor Robert Shiller, the man who wrote the book on 1990s irrationality. "They're thinking, 'The market had better come back.' "

It is a dangerous instinct. Call it "irrational protuberance" -- the tendency to stick your nose out too far and in the wrong places. So emotion, frustration, nasal extension aside, what is the best way to play the recovery? How can you wade into the rising tide without finding yourself in over your head?

To answer that we went to the proverbial smart money -— that rare breed of investors who seem to do well in good times and bad. We canvassed not only leading money managers but also the best market strategists, academics, financial planners, institutional traders, and economists we know. The list includes fabled names like Bill Miller, whose Legg Mason Value Trust is on track to beat the S&P 500 for the 13th straight year, PIMCO's Bill Gross, Oakmark's Bill Nygren, and economists Burton Malkiel and Jeremy Siegel. We also interviewed lesser-known, but longtime hot hands like Neuberger Berman's Marvin Schwartz, who has beaten the market 27 out of the past 39 years; Pioneer's high-yield bond guru Margie Patel; and fund manager Ron Muhlenkamp, whose eponymous fund has beaten the S&P 500 by two percentage points a year on average for the past decade and a half. (You'll find specific advice from six of our investors on key topics in Six Strategies for Investing Now.) In all, we picked the brains of more than three dozen market veterans, and while there were a few serious disagreements about the market's near-term direction, there was clear consensus on some critical points.

We've Been Here Before
Start with the biggest piece of good news. Despite the litany of dramatic events in the past few years—the collapse of the tech bubble, the attacks of Sept. 11, corporate accounting scandals, and the war in Iraq—the economy hasn't been thrown off its axis. If you take a step back, say most veteran observers, the long economic slowdown now clearly looks more cyclical than secular. To some extent that means that you can trust the fledging signs of recovery for what they are, and not assume that they are some nasty sleight of hand in a new economic order.

"We're simply coming out of a regular cyclical recession," says Muhlenkamp, a 35-year industry veteran who relies heavily on economic analysis in his value-oriented fund. "We're seeing normal patterns here. We used to expect one every five years. But this is only our second recession in 20 years, so we've got a whole generation of people who don't know how the economy acts or the market acts coming out of one." Muhlenkamp has overseen a 26 percent rise in his fund year-to-date by buying into the cyclical stocks—like homebuilder Centex and textile maker Mohawk Industries—that lead a recovery.

It's also important to remember where we are not, and that's 1982. This June probably marked the endpoint of a 20-year drop in interest rates, a critical part of the engine that powered the long bull run. "That was the low point," says Wharton's Siegel, whose Stocks for the Long Run remains a seminal text for investors. "I don't know if we're going to reach that point again in years or decades. This is a watershed shift that's taking place. Interest rates are going to have to move higher for the foreseeable future."

So where does that leave us? Pull out your go-go boots and flowery shirts. "This decade is much more likely to be akin to the 1960s," says Andrew Spencer, chief investment officer of J.P. Morgan Fleming's U.S. retail business. "A few good years, then a gloomy year. The markets will reflect the growth of the underlying economy."

Dial Down Expectations
If there's one thing that smart investors agree on, it's that for the next decade at least, we are unlikely to see the 10 percent annual returns that stocks have averaged since 1925, according to the calculations of Ibbotson Associates. And we certainly will not see the 18 percent annual returns of the 1990s. "All my work suggests the markets are very reasonably priced given the level of interest rates today and the fact that inflation is low," says Princeton economist Burton Malkiel, author of the classic A Random Walk Down Wall Street. "But we've got to reduce our expectations. We are in a single-digit world."

Blame history for that. Stocks were basically undervalued for most of the past century. The falling inflation and interest rates that made stocks so attractive in the early 1980s, driving millions of Americans—and trillions of their dollars—into the equity markets, led to a great expansion in P/E multiples. "Over history, stocks have been too good a deal," says economist Cliff Asness, who runs the $5 billion hedge fund AQR. "That deal is no longer being offered."

The only way to get back that deal isn't pretty. Stocks would have to fall sharply from current levels, a scenario that some believe is not only possible but inevitable. Jeremy Grantham, chief strategist and chairman of GMO, a $25 billion money-management firm, believes we are in "a spectacular bear market rally." He warns that "the market can hang in and do okay, up or down 10 percent, through the [2004] election. But following the election it will be a black hole.

Most others, however, believe that 6 percent to 8 percent annual returns over the next several years is a sustainable pace for equities. If the heady six-month stock rally tempts you to think that range is conservative, snap out of it. The market looks somewhere between fairly valued and slightly overvalued after the run-up.

It's a Stock Picker's Market
But remember, that's the overall market. While the average P/E of the S&P 500 is about 20, Muhlenkamp points out that its median, using 2003 estimated operating earnings, is closer to 17. Within that universe there are as many bargain-priced companies as boondoggles.

This simple observation and the fact that the market's overall growth is likely to be stunted leads several of our smart-money crowd to predict, for the first time in a while, that index funds probably won't get you the best returns. To be sure, you're definitely safest keeping the lion's share of your investing assets in low-fee, broad-based indexes, such as those run by Vanguard. But to juice what are likely to be unspectacular returns, you've got to separate the real values from the pack.

A straightforward way to beat the averages is to bet on dividends. In an atmosphere of modest gains, why not start out with some (almost) guaranteed return? From 1926 through July 2003, 42 percent of the market's total return has come from dividends. So far this year non-dividend-paying stocks have outperformed the payers by a substantial margin. But that's likely to change as the furious tech rally wanes. Companies, certainly, are sensing the opportunity of a flood of yield-searchers. Since the start of the year there have been 171 dividend increases and initiations of dividends—up 50 percent from 2002's total. This reverses a 20-year decline in the number of S&P 500 dividend payers. Credit the recent dividend tax cut (which lowered tax rates on dividends to 15 percent).

There is another powerful reason to expect dividend stocks to do well—demographics. As baby-boomers move into retirement age, there will be millions of formerly risk-tolerant investors craving the security of income. "You're looking at a sea change in the investing population from people looking for growth to investors who want capital preservation," says Kari Bayer Pinkernell, senior U.S. strategist at Merrill Lynch. Pinkernell and her colleague Rich Bernstein like high-quality energy and industrial stocks as a play on dividends.

Just as the pendulum is likely to swing toward dividend payers, both lower P/E stocks and higher-quality companies (defined as those with stronger balance sheets and credit ratings) are going to soak up the biggest gains, our experts predict. So far, in the easy-money rally we've just seen, the opposite trend took hold: High P/E (or no "e") companies outreturned their bargain-priced peers by a factor of nearly five to one, according to Birinyi Associates. You can almost hear the rubber band snap.

Hedge Your Bets
More than $20 billion has flowed into hedge funds year-to-date, according to TASS Research. That already surpasses the $16.3 billion net inflows from all of 2002. Institutional and high-net-worth investors are clearly beginning to embrace hedging strategies.

Mary Erdoes, head of investments at J.P. Morgan Private Bank, says her clients are "diving back into equities." But they are doing so by shifting into hedge funds or equity-linked investments that guarantee you'll at least get back the capital you put in. Other investments make use of built-in "put" and "call" options, which let you sell or buy a given number of shares at a set price by a certain date, allowing you to grab most of the potential upside in a stock while limiting the downside risk. "Almost every day our clients ask us for some form of structured equity," says Erdoes.

The simplest way to hedge your bets, of course, is to diversify. With the demand for real estate showing no significant signs of decline, it makes sense to continue holding REITs in your portfolio. And the bear-minded Grantham suggests investing in timber stocks. "It's the only asset class that's very negatively correlated with the stock market," he says.

Get Creative With Bonds
Bonds, of course, have long been the traditional hedge for stocks. If you were lucky enough to have bet big on fixed-income securities for the past three years, you have probably made a bundle. But as interest rates began to bottom this summer and prices topped out, the fixed-income market was due for a fall. That happened in June when ten-year Treasury yields shot up from a historic low of 3.1 percent to 4.5 percent. In fact, bond prices have corrected so much they don't look half bad.

Still, with interest rates set to rise at some point in the future, we aren't looking at the same hospitable atmosphere for bonds we've had for the past two decades. "For the next 12 months, these levels will hold; the damage for the near term has been done," says PIMCO's Bill Gross, who manages the world's largest bond mutual fund. "On a longer-term basis, the Fed is in an announced era of reflation. That's not a positive for bonds."

The best strategy is not to abandon bonds but to be more creative with the way you play them. One measure Gross is taking is to buy TIPS (Treasury Inflation-Protection Securities), which hedge against rising inflation. Because TIPS currently offer higher rates than their historical norm, there's a chance prices could actually rise in this bond category if real yields fall in the next few years. Bond laddering, or buying individual bonds or funds of different maturity to spread out your risk profile, is always a good idea. Bond managers have been shortening the duration of their bond ladders recently in expectation of rising rates.

Rising yields and the anticipation of higher inflation have put a damper on what has been a banner run for junk bonds, but Margie Patel, manager of the Pioneer High Yield fund, says they can still be a valuable tool in retirement accounts. The trick is to harness the 10.4 percent average yield and reinvest that hefty payout into the fund, especially in a 401(k) where income isn't taxed. "You can use that coupon flow to dollar-cost average," says Patel, "either by buying more of what you own or redirecting it into something else." She also points out that junk is actually getting safer these days: For the first time since mid-2001, the junk-bond default rate has fallen below 10 percent, to 7.7 percent.

Think Globally
It is nerve-racking enough, you might think, to put your money into plain old American stocks right now, much less venture out into the big, scary world. And that's especially true if you had money in Russia or Asia in the late '90s. But in investing, the safest route is rarely the most profitable. And there are compelling reasons to look abroad (see Wall $treet Week with FORTUNE's May 23, 2003 interview with Jim Rogers for more).

"The argument for international markets is twofold," says Hilda Ochoa-Brillembourg, CEO of Strategic Investment Group and former chief investment officer for the Pension Investment Division of the World Bank. "They are cheaper than the U.S. And in a time of terrorism risk, one good way of diversifying is to have your assets spread out in more parts of the world."

Mark Mobius, whose Templeton Emerging Markets fund is already up 50 percent this year, is particularly excited about Asia, where markets are recovering from the economic crises and currency devaluations that have plagued them recently. "We're seeing amazing bargains," says Mobius. "By any valuation method you come up with, these companies are cheap. We're finding terrific opportunities."

One smart way to expose yourself to this asset class is through the no-load Vanguard Emerging Markets Stock Index (VEIEX) fund, which has very low expenses and a one-year return of 23.7 percent.

Looking abroad can even be helpful with cash. Erdoes of J.P. Morgan says some clients have been moving money into foreign currencies, such as the Australian dollar, where overnight money-market rates are much higher. Yes, money makes money. The smart money simply makes more of it.

Additional reporting: Anna Bernasek, Doris Burke, Janice Revell, David Rynecki, and David Stires