(FORTUNE Magazine) – To many investors, the failure of blue-chip stocks to keep pace with their explosive Internet cousins in recent years has smacked of unfairness. The yowls of protest are familiar to anybody who follows the stock market: Where are the profits of the Internet companies? Heck, where are the revenues? In fact, the seemingly independent paths of these types of stocks have left many scratching their heads (for more on that issue, see "Market Madness: What the Hell Is Going On?").

But one significant explanation for the relative underperformance by pre-Internet companies seems to have been largely ignored: Profit margins have been sagging for a while now. Since peaking at the end of 1997, they have been steadily deteriorating. According to the U.S. Bureau of Economic Analysis, profit margins of nonfinancial companies ended below 11.5% in the third quarter of last year, compared with their peak of close to 13%. That's a drop of more than 10% in just two years. "The problem for every company now," says Marshall Acuff, equities strategist for Salomon Smith Barney, "is that it's become even more challenging to manage profitability than it was a year ago."

There are plenty of culprits. Competition from the global economy and from neophyte companies on the Internet is keeping a lid on the prices that companies can charge.

Worse, costs are on the rise. Until recently, everything on the cost side was working in favor of corporations: Interest rates were falling, energy and commodity prices were weak, and labor costs were dropping. Now those factors are starting to unravel. The Fed has raised short-term interest rates by one percentage point since last summer and is widely expected to raise them by at least another full percentage point by year-end. That amounts to a big increase in finance costs, especially at a time when corporate debt burdens are high for established companies. Meanwhile, energy prices, led by oil, are going through the roof.

But the real test for margins is what's going to happen to labor costs. The growth rate slowed at the end of last year but shows signs of picking up again. "I expect labor costs to rise a bit faster this year," says Richard Rippe, senior economist at Prudential Securities. "Not significantly," he emphasizes, "but they will rise." Given that labor costs make up a whopping 70% of corporations' total expenses, even a small increase will be felt.

It's not just the cost side of the equation that looks gloomy. The outlook for revenues is dark too. Fed Chairman Alan Greenspan has vowed to raise rates until demand is dampened, in an effort to stave off inflation. The chairman aims to temper consumer spending on things like housing, cars, and household items. That will hurt firms' revenues, especially at a time when raising prices is out of the question. "If Greenspan is successful in slow- ing down this economy," says Salomon's Acuff, "then the pressure on profits will intensify." Given how successful Greenspan has been in his job to date, that's a safe assumption to make.

It's not a pretty picture. The cost line is trending higher while the revenue line is trending lower. It adds up to one thing: a classic margin squeeze. "It's as close to a sure thing as you can get," predicts Mark Zandi, chief economist at RFA Dismal Sciences, "that margins will be squeezed this year." Not exactly the most favorable environment for stocks, is it?

But before you opt out of the market, consider this: Not all companies will fare badly. The trick in picking stocks this year will be to figure out which can best manage their profitability. Look for companies with low debt, little exposure to energy costs, and an ability to defer labor costs, say, in the form of offering their employees options. (Does that ring any bells?) But don't stop there. Make sure those companies can either increase their market shares or operate in markets growing much more rapidly than the rest of the economy. Sounds familiar, doesn't it? Tech and Internet stocks seem to fit the bill, which should help explain why those sectors have been so popular and investors have been prepared to pay such high premiums. In the short run at least, the margins of tech companies do appear far less affected by the macro forces growing out of today's economy than the old-economy sector.

There are, however, some nontech stocks that also fit the bill. Portfolio managers like Jeff Van Harte, at TransAmerica Investment, say there are companies out there that will do well in this environment. "You just have to look for companies that sell better products at lower prices," he says, and points to stocks like Gap, UPS, and First Data as examples of his current favorites. (For other stocks poised to succeed, see "This Week's Specials.")

Greater competition has always helped corporate America become stronger and more dynamic. And that may turn out to be the case for many of today's struggling old-economy types. Even though firms face higher costs and lower revenues in the short term, they're unlikely to sit by helplessly, watching profits dwindle. Finding ways to increase productivity, eke out greater efficiencies, or restructure operations would help offset an impending margin squeeze. But that won't be easy, given that most companies have already made many such changes.

So, for the moment at least, there are good reasons why shares of General Motors and Ford are trading at low multiples and the stocks of big-name consumer-brand companies have been hammered. None of this means, of course, that tech stocks actually deserve their stratospheric valuations. What it does mean, however, is that many old-economy stocks have earned their more earthbound price tags.

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