(FORTUNE Magazine) – The November elections, if nothing else, were decisive. And thank goodness for it. Many of you may wonder how anyone not under a rock these past few weeks (is it only weeks?) of recounts and too-close-to-calls and bitter partisan battles in the courtroom could ever say that this election was decisive. After all, not only is the very presidency uncertain (at least as of press time) but the Senate is cleaved into two nearly even political halves, and the sharp Republican edge of the last Congress has been filed down to a nub. But then, that's just the point. The strange chemical balance in the Beltway--two parts citric acid, two parts soda ash--is a recipe for fizzle, not combustion. The American electorate, in its infinite wisdom, has chosen not to blow the economy up in the next couple of years--whether through enormous tax cuts or sudden budgetary splurges--but to leave things pretty much as they are. Hallelujah!

With so little mandate for either party (and plenty of heaving resentment on both sides of the aisle), there's a good chance that a do-nothing Congress could meet a do-nothing President right at the Capitol Hill DMZ. And that, with a bit of luck, would leave the budget surplus intact and Fed Chairman Alan Greenspan steering the economy. An ideal situation for financial markets.

Then why all the angst? The Nasdaq has shed more than a third of its value from its March high, the Dow has lost 7% since the start of the year, and there's a general sense that the market is dying by 1,000 little cuts. It all seems as if the new economy were crumbling and a recession looming. Investors are clearly skittish, if not outright scared.

The question on everyone's mind is, What will the markets be like in 2001--more of this year's downward spiraling path or a much smoother ride? The answer, in all likelihood, can be found in the overall health of the economy. The stock market will be--as it has been through virtually every bull and bear--a fair reflection of the American economy itself. And the good news is that the expansion is in no danger of ending anytime soon. In fact, even though growth is slowing from an extraordinary pace, it is forecast to remain at historically high levels. So as far as economists are concerned, many have expressed confidence that it's only a matter of time before the market snaps out of its funk. "We've gone from being too exuberant to too pessimistic," says John Lipsky, chief economist at Chase Manhattan Bank. "It might take a couple of more quarters before the mood brightens, but it will brighten."

How the market finishes the year is still too difficult to call. But in many ways the outlook for the economy in 2001 is far more predictable. More than a dozen economists interviewed by FORTUNE have painted a consensus scenario, if you will: Business investment will drive growth, the tech sector will remain the economy's hot spot, the U.S. will still be the place to invest on the global scene, and most important, interest rates will fall. All that adds up to good news for stocks.

Yet tempering that optimism with a liberal dose of realism, we've also clearly entered a new phase in this expansion--one that means more moderate growth for corporate earnings and less meteoric stock price gains. (Yes, we can see the self-help books coming to the shelves: That Was Then, Investors, This Is Now and Learning to Live With Less.) There are strong reasons to expect that stocks should perform well, but folks, it's evident that the stratospheric market gains of recent years are over--at least for a while. And in this new period, stock picking and investment strategies will be more critical than ever.

The key to any diagnosis is first to check the vital signs: To start with, economic growth this year is on track to come in at 5% or better, and inflation is running at 3.5%. Next year, according to Blue Chip Economic Indicators (a consensus forecast from the country's top 50 economists), the economy will grow at 3.5%, and inflation will run at 2.5%. By historical standards, that's impressive. Long-run noninflationary growth has averaged 2.5% a year, but thanks to the new economy, most economists now believe that we can grow consistently between 3.5% and 4% without triggering rising prices and wages.

It may seem perverse, even masochistic, that economists take pleasure in a slowdown, but then the essential word in all this is sustainability. Remember back at the beginning of the year, when Fed Chairman Alan Greenspan was huffing and puffing about the stock market, the wealth effect, and consumers? He was worried that consumers were spending way ahead of what firms could keep up with, and the effect, he said, would be spiraling prices and wages. Luckily, Greenspan was decisive, acting (in the face of opinion polls, we might add) to slow consumer spending through six consecutive hikes in interest rates. And the plan has worked. Consumer spending adjusted for inflation is still growing, but it has moderated to a 4.5% growth rate in the third quarter from its supersonic clip (8%) at the start of the year; wage and price pressures, meanwhile, remain in check.

That has left business investment as the main engine of growth in the economy. And it can pack a powerful punch. Consider that business investment in new technology and equipment accounted for 30% of the nation's economic growth during the past five years. As firms have spent more money on new technology and other capital goods, they've increased their efficiency, reduced costs, and boosted the productivity of their work force. This has allowed the economy to grow faster without price pressures and has underpinned accelerating corporate profits.

Business investment has been the important ingredient in the new economy, and it's the key to our future performance. If business investment dries up, so too will productivity improvements and economic growth. But what are the chances of a precipitous dropoff in business spending? Slim, argue economists, as the critical factors driving companies to invest remain in place today: Interest rates are still low, competition in the global economy is as fierce as ever, and the fast pace of technological change is forcing firms to keep up or lose out to their rivals.

Though companies may not spend as much in the year ahead as they react to the slowdown in consumer spending, they will continue to spend. In the coming year economists such as Lipsky at Chase forecast that business spending will grow by 10%, compared with the 15% pace of the past few years. What may be more revealing about future capital spending, though, is that new orders for durable goods show no sign of easing.

The bottom line, of course, is what impact this less exuberant new economy will have on corporate earnings. And you guessed it: Earnings growth will shift down a gear too. Rather than the 15%-plus growth rates of recent years, most economists are expecting a 10% increase in earnings per share for the S&P 500 next year. "That's still very healthy earnings growth," says Bruce Steinberg, chief economist at Merrill Lynch, who forecasts the same rise. Mary Farrell, senior investment strategist at Paine Webber, agrees: "We should have a reasonably good environment for corporate earnings next year."

A good guide to the performance of stock prices is the direction of interest rates. Rising interest rates are bad for the stock market, and they're especially damaging when it's unclear just how high rates will have to rise. That's not the situation we're in now, though. The Fed hasn't raised rates since the beginning of summer because the economy is responding the way it should. And Greenspan and his colleagues at the Fed seem to believe that further interest rate hikes are no longer needed. In fact, the Fed said at its last meeting, on Nov. 15, that the economy was indeed slowing down, confirming that its policy had been working. Markets now expect the Fed to remove its tightening bias at its first meeting in the new year, signaling an end to the cycle of rising interest rates.

The big issue for 2001 is whether the Fed will cut interest rates and by how much. Looking at the Treasury-bill market, traders have already factored in a 50-basis-point easing in rates in the first half of next year. And many economists also predict an easing in the year ahead, although most aren't specific on size or timing. It all depends on whether price and wage pressures remain in the economy, they say. What Greenspan is worried about is the state of the labor market. (The latest figures show that unemployment dipped to 3.9%, increasing the risk that wage pressures could still be mounting.)

So how much will inflation be tamed by the slowdown in growth? That's the x factor. If the answer is not much, then the Fed will be reluctant to ease rates. If inflation keeps falling, Greenspan and company will be more generous with rate cuts. Although most Fed watchers expect a cut in rates next year, there is a note of caution. Economists are fond of saying that prices and wages may be "sticky downward." That means that even when the economy slows, prices and wages may not respond instantly. "The Fed could be slower to ease than everyone thinks," warns William Dudley, an economist at Goldman Sachs. "The tradeoff between growth and inflation may not be immediately favorable." That doesn't mean rates won't come down. It just means it might not happen in the first quarter of 2001.

Regardless of the timing, the interest rate environment has shifted from a clear negative factor for stocks to a mildly positive one. And when the Federal Reserve does ease policy next year, the interest rate environment will become an even stronger positive force for the market.

Another factor clearly in the market's favor is the state of the global economy. Rising oil prices and higher interest rates in Europe and Asia are leading to a slowdown in much of the world. The IMF in its latest World Economic Outlook predicts that the European Union will grow at 3.3% and Japan 1.8% in 2001, and the global economy will slow to 4.2% next year from the current 4.7%. That may seem negative, but it's actually a boon for the U.S. economy and financial markets.

In the past five years the U.S. has benefited from massive foreign-capital inflows, helping to fund the investment boom that has driven the expansion. Foreign investors have increased their holdings of U.S. Treasuries from 17% to 34% and stocks from 25% to 33% since 1995 as America has offered the most attractive investment opportunities. And in 2001 the course looks the same: Our markets should continue to benefit as the rest of the world weakens. "The best-performing economy in the year ahead will still be the U.S.," predicts David Resler, chief economist at Nomura Securities International, a division of Nomura, Japan's largest bank. "International investors will have to maintain a high exposure to the U.S., and that will help our economy and market."

All this cheery news doesn't mean there aren't risks. And here the political environment can't entirely be ignored. The next President will go into the White House with the narrowest governing margin in recent history, as we said. So yes, under those circumstances, big-ticket items such as sweeping tax cuts or major spending proposals will have to be modified before they can pass muster. But there will still be a tendency toward spending the budget surplus among both the legislative and executive branches, and that will have the effect of stimulating the economy.

More troubling, there is the possibility that a divided Congress might find it easier to spend a big chunk of the surplus--either by a grand compromise in which the two parties agree to both mammoth tax cuts and generous spending increases or by ginning up lots of little deals that add up to big bucks. In that case the interest rate environment would be affected. Here's why.

The prospect of an unusually large fiscal boost to the economy could fuel anxiety over future inflation. That would either prompt the Fed to raise interest rates--if the economy were running at its speed limit--or discourage it from lowering rates as quickly as it otherwise might if growth were slowing. Both scenarios would be negative for stocks.

With any new Administration, there's also the risk from new appointments. And that's probably the biggest unknown facing financial markets at the moment. In terms of the economy, the most important position is up for grabs: Secretary of the Treasury. What could frighten Wall Street is a Treasury Secretary who might have limited experience working in or with financial markets. And on that score, investors watch carefully to judge the experience of candidates and their policy biases.

The market's response to Larry Lindsey, for example, as Treasury Secretary in a possible Bush Administration could be less than warm because of his lack of direct financial market experience and a perception that he's more ideological than pragmatic. That should be tempered by the fact that Lindsey served on the Fed board for six years until 1997. But the bottom line is that the Street may prefer someone in that position with not just ordinary but extraordinary financial market savvy. Like Bob Rubin, for instance, who ran Goldman Sachs before joining the Clinton Cabinet.

And what of the Fed in the new Administration? That's another issue that has traders on edge. There are two and possibly three positions on the Fed board to fill. While everyone recognizes that the power at the Fed resides with the chairman, electing three out of seven positions on the Fed board could change its composition. Part of Greenspan's success has been having like-minded governors on the board who believe that the Fed should act preemptively to fight inflation and--equally important--who are willing to give the new economy a chance. That may not necessarily be the case if new members are elected. While three new members would not constitute a majority on the all-important FOMC (Federal Open Market Committee--the 12-member committee that votes on interest rates), they would still be an influential bloc. In the current context, they might believe inflation wasn't a problem and vote to lower interest rates aggressively. Or, conversely, they might not believe in the sustainability of new-economy output and vote to raise interest rates in order to slow down growth even more. (Here they'd find support among some members of the FOMC but not Greenspan.)

Add to this question mark a number of nonpolitical risks. The big ones include the ballooning current-account deficit, an energy crisis, and rising household debt. It's not that any of those concerns have suddenly appeared on our radar screen. In fact, all three have been part of the economic picture this past year. So how exactly could they be problems? A large current-account deficit leaves the economy and the dollar vulnerable to changes in investor sentiment, especially a sharp reversal of those now-critical foreign capital inflows. A sustained energy price hike would increase the danger of growing inflation, while record levels of household debt leave consumer confidence and spending vulnerable to any negative changes in the economy.

Although it's unlikely that any of those factors would play out to truly undermine the economy and send it into recession, together they create a level of heightened uncertainty that hasn't existed in the past two years. What makes matters worse is that the economy is more vulnerable to shocks when growth here and abroad is slowing down. The riskiest time may be the first half of 2001. The reason: Most of those forecasts for 3.5% average annual growth assume a slower pace in the first and second quarters. With the economy running at what is essentially stall speed, any large shock could make for a hard landing.

Where does all this leave investors in 2001? Wall Street's top strategists and economists are in agreement: Be prepared for average returns in the stock market of closer to 10%, rather than the 15% to 20% of the past five years. "Investors have to realize we're in a new environment," says Dudley of Goldman Sachs. "The stock market will do fine next year, but we need to understand that 10% returns are now more realistic." And with inflation expected to run at 2.5%, real returns would be around 7.5%, in line with the 8% average real return from the S&P 500 since 1927, according to Ibbotson Associates.

Another message to investors from Wall Street's top advisors is this: Be prepared for a bumpy ride in the year ahead. With heightened uncertainty and a tricky ongoing adjustment to lower earnings growth, volatility will remain the order of the day. "The uncertainty factor is clearly going to be an issue for investors next year," cautions Richard Berner, chief U.S. economist at Morgan Stanley Dean Witter. "If this year has reminded investors that there are risks as well as returns in the market, then we might start to see a balance in how people approach their investments." Unfortunately, there's little that investors can do to avoid market volatility except increase their portfolio diversification, keep an eye to the long run, or get out altogether.

Forget the long run, you say? What about doing better than the market--a lot better? Well, yes, that is the whole point of savvy investing. And according to UBS Warburg's chief global strategist, Ed Kerschner, there may indeed be a way to outperform. Even though the economic environment should be positive and fairly reliable as we get back to "normal returns," he says, there will be times of high investor anxiety. That should translate into rare periods of extreme undervaluation. Kerschner believes we're currently experiencing such a period because of concern over what he calls the "four E's"--energy, the euro, earnings, the election--and he advises investors to take the opportunity to buy the market.

It will be more important than ever in this new subdued investment climate to pick sectors carefully. "Defensive" is the buzzword to keep buzzing in your head. That means you should buy stocks in firms with earnings that are less vulnerable to a misstep or slowing in the economy. Doug Cliggott, strategist at J.P. Morgan, says health care, food and beverages, and other consumer staples fit nicely into that category. And many equity strategists advise buying into those sectors now, as the market adjusts to lower growth. "You need a broad portfolio of stocks to start with," Cliggott says, "but then you should be overweight in areas where earnings aren't tied to the business cycle."

And what of the tech sector? Will the current tech rout continue, or will the sector rebound? There's both good and bad news on that front (as we reported in FORTUNE's Nov. 27 cover story). The good news is that economists are in overwhelming agreement that technology will remain the fastest-growing sector in the economy. It's still the place to be in the market. And the bad news? The tech sector isn't immune to the slowdown in economic growth. Even though firms will keep spending on technology, they will spend less as they react to the slight retreat of consumer spending.

But here's the upshot: The slowdown in the tech sector won't be anywhere near the falloff in the rest of the economy. According to Wesley Basel, a senior economist and tech industry expert with Economy.com, one of the country's largest economic consulting firms, spending on technology may drop by one-third in the year ahead, while spending on nontech industrial equipment could be halved.

Don't assume, however, that this makes a compelling case for buying the Nasdaq across the board. For in the tech sector, as in the broader market, some stocks and sectors will be clear winners while others are left struggling behind. Basel and other economists, for example, believe that the semiconductor industry appears to be operating at overcapacity, especially in light of a weaker global growth environment. But economists think strong growth is likely for network and database systems as firms spend more on their Web infrastructure.

For those seeking a bit more safety and stability, the bond market may be a good place to start. After several years of looking like a poor cousin to stocks, bonds are back in favor and should remain that way--at least during the first half of 2001. Slowing growth combined with an interest rate cut on the horizon is always upbeat news for the bond market. But like their equity counterparts, bond strategists caution that not all bonds are the same. "Credit quality and liquidity will be the two big issues next year," says Bill Hornbarger, chief bond strategist at AG Edwards. In that regard, Hornbarger advises investors to avoid high-yield corporate bonds (the ones we impolitely refer to as "junk") and stick with large household issues, such as GE and Disney. And in the Treasuries market, he points to intermediate and long-term securities with five- and ten-year maturities.

While the economic picture looks pretty pink, if not quite rosy, smart investors shouldn't relax too much. Two key factors arising next year could affect the market--even dramatically change the investment climate on short notice--so it's a good idea to keep an eye on them: interest rates and the federal budget. Look for interest rates to dominate the first half of the year, and be ready to buy stocks if the Fed decides to cut rates. Alternatively, if the Fed holds off, look for the bond market to outperform stocks.

In the second half, the debate over fiscal policy should be in full swing, and by then American voters should have a clearer idea of their government's view toward fiscal restraint. At that time we should also know whether the economy is picking back up--or continuing to slide.

Perhaps the best advice to keep in mind for the year ahead is the oldest: Diversify your investments. "At the end of the day, I'd go into the new year with a little more cash than normal, some index-linked securities, and a defensive equity portfolio," says J.P. Morgan's Cliggott. "And then I'd be ready to change as things unfold."

That's about the only thing you can count on in 2001: Things will unfold.

FEEDBACK: abernasek@fortunemail.com

REPORTER ASSOCIATE Lenore Schiff