NEW YORK (Money Magazine) - Deciphering the direction of the stock market is one of Wall Street's favorite parlor games. But there are far more profound and, let's face it, useful insights to be gleaned from Wall Street's top gurus.

More from the Ultimate Investment Club • Opportunist picks: Bill Miller, more • Bond picks: Bill Gross, more • Value picks: Chris Davis, more • Strategist picks: Steve Galbraith, more • Growth picks: Thomas Marsico, more

By talking with a handful of the very smartest ones, you can get a strong feel for the range of risks and opportunities available to investors. Though not foolproof, their views (as well as their stock recommendations) are always a smart place to start.

Steven Galbraith, the chief U.S. strategist at Morgan Stanley, is Wall Street's most respected soothsayer right now. His balanced and nuanced interpretations of the financial markets have provided valuable guidance during a difficult-to-understand period.

Top picks Strategist  Pick  Robert Arnott  Vanguard Emerging Market  Steven Galbraith  Dow Chemical  Steve Leuthold  Ivax  Diane Swonk  Trinity Industries   Source: Money magazine 10/2003

This summer, at the invitation-only MONEY Summit of top financial leaders, and again when we quizzed him for this story, Galbraith made the case for the underlying strength of the American economy. The fundamental backdrop for stocks is improving, he says: Profits will continue to increase in the second half, while rates will only creep up in the coming year, creating a positive environment for recovery.

But Galbraith is not all smiles and good cheer. He expects the cost of treating stock options as an expense and making contributions to under funded pension plans to cut into S&P 500 earnings by $5 a share next year.

And he cites a more basic reason for caution: valuations. While he thinks equities are the place to be for most investors, he stresses that after a 16 percent run-up this year, the market has less room to rise.

Still, there are opportunities, Galbraith says.

For example, he likes Dow Chemical (DOW), trading at $33, with a price/earnings ratio of around 17, based on estimated 2004 earnings. He believes that the chemical industry will get a powerful boost as the economic recovery accelerates. Galbraith also predicts that Congress will pass tort reform that will put a lid on the asbestos liability that has been holding back the stock.

Steve Leuthold, head of Leuthold Weeden Capital Management, takes a somewhat different position -- one that represents a dramatic change from his late 1990s stance. Back then, he was a bear (he even launched a fund called the Grizzly Short fund). But starting last fall he turned bullish, recommending stocks to the 200-some financial institutions that subscribe to his highly regarded independent research.

Leuthold says stocks are cheap. Based on an average of the past four years of corporate earnings and this year's projections, he figures, the S&P 500 has a P/E of 21.6. Historically that's slightly above average, but the past seven bull markets have started with stocks at average valuations, not lows.

And those pension contributions that concern Galbraith? Leuthold agrees that they'll depress earnings but argues that a lot of that money will end up in the stock market, helping to support prices.

Leuthold has 36 percent of his portfolio in health-care companies, which should benefit as older Americans need more medications, hip replacements and heart bypasses.

He particularly likes generic-drug firm Ivax (IVX). At $19, the shares have a 35 P/E on 2003 earnings, which Leuthold says is high but attractive for a firm poised to benefit from a trend "that's about as strong as you can get." Ivax has a healthy pipeline of drugs awaiting FDA approval, with treatments for brain cancer and epilepsy in trials.

Diane Swonk, chief economist at Bank One, shares Leuthold's optimism. She's focused less on valuations and more on the mix of tax cuts, deficit spending and low interest rates that President Bush and Alan Greenspan have used to prime the economy.

"We have good, overzealous policymakers willing to overheat the economy to get it back on track," Swonk says. She predicts that the S&P will rise 20 percent in 2004 and expects impressive returns from stocks through 2008.

Might all that stimulus cause problems down the road? Bingo! says Swonk, especially as the country's debt rises. She predicts that the current economic upturn will end in five years with far higher inflation and a worse recession.

One area where she sees opportunity today: transportation. She notes that Bank One chief investment officer Larry Baumgartner recommends Trinity Industries (TRN), which makes railroad cars. As the economy picks up steam, railroads will need to revitalize aging fleets. Baumgartner thinks that Trinity, trading at around $26, can boost earnings to $5 a share in the next few years.

Not all our gurus see bright short-term prospects for U.S. stocks. Robert Arnott, chairman of money-management firm First Quadrant, which oversees $15 billion in assets, points out that by almost every measure, the S&P trades near historical highs. Leuthold's view that the market is fairly valued relies on analysts' upbeat projections, which, Arnott notes, are often wrong.

What's more, Arnott expects stock option and pension expenses to knock $14 off S&P earnings in 2004. And with baby-boom retirees poised to pull huge sums out of the market in the years ahead, his sobering view is that this rally is an aberrant one-year pop -- and that stocks will deliver average gains of 2.7 percent a year after inflation for the next 20 years.

His advice: Look abroad. He points to Vanguard Emerging Market Equity Index fund (VEIEX) as a cost-effective way to invest in Third World markets. Arnott says shares of Third World companies are cheaper than their developed-country counterparts -- and those markets don't face the same demographic problems as the U.S.