(FORTUNE Magazine) – A year ago New York neurologist Asa Abeliovich confidently plowed $15,000 into the market and watched his stock picks rise smartly through 2003 and into early 2004. Abeliovich was all set to invest another $15,000 this spring--he even transferred the money from his savings to a brokerage account--but the sagging stock market has made him hesitant to pull the trigger, and the money is still sitting with E*Trade. If Wall Street rallies, he says, he might break down and buy some of the biotech names he's been eyeing for months. "In the past couple of weeks I've looked but not made any moves," Abeliovich explains. "The headlines are so negative and the market is so volatile, it's pretty hard to feel confident."

A lot of investors these days can relate to the good doctor's dilemma. After enduring a three-year bear market, shareholders were rewarded with robust double-digit gains in 2003, and the first two months of this year promised more of the same. In fact, in the first quarter of 2004, a record $135 billion poured into U.S. equity and balanced funds, according to Strategic Insight--more than flowed in even during the height of the tech bubble in early 2000. But the breezy optimism most investors shared a couple of months back has all but dissipated amid the violence in Iraq, $40-a-barrel oil, and the prospect of higher interest rates. A sharp de-cline in the first half of May has left the S&P 500 down just under 1% for the year.

The abrupt change in sentiment is actually the good news, says veteran Morgan Stanley strategist Byron Wien, noting that overconfidence usually precedes a dip in the market rather than a rally. "Before, people felt that nothing could go wrong, and there was an excess of enthusiasm," says Wien. "The general mood has to turn negative before the market can go up." The bad news is that the market is being buffered by strong forces--especially the interest rate and oil-price worries--that have battered stocks in the past. And with the next wave of earnings news not out till July, the market might well remain focused on the negatives for now.

What's more, individual investors like Abeliovich aren't the only ones staying on the sidelines. Institutional players such as mutual fund managers are unlikely to want to commit to the market before the Fed meets in late June and, in all probability, raises rates by a quarter point. Though the market has long known the Fed would inevitably raise the interbank rate from its current 46-year low of 1%, until May the conventional wisdom was that the hikes wouldn't happen till August at the earliest. With job creation finally picking up, it looks as if the first move will come next month. "The market won't hit bottom until the Fed takes its first step," says David Wyss, chief economist for Standard & Poor's. "The earnings reports this summer should be strong, which will help, but the focus is going to be on rates."

So what's the best way to play a volatile environment dominated by headlines and the prospect of Fed rate hikes? Like many other gurus, Wyss has gone back and examined the markets' performance in 1994--the last time the Fed began raising rates after a prolonged slowdown. In the three months surrounding the Fed's first rate hike in February 1994, stocks dropped 9%. Although the market eventually rebounded and the S&P managed to eke out a slight gain in 1994, Wyss says that kind of sharp drop is typical when the Fed signals it's getting ready to tighten the reins. "Although it's clear the Fed will raise rates very gradually, the bond market tends to overreact in the early stages," says Wyss. Indeed, the yield on the benchmark ten-year bond has soared from 3.8% to 4.8% since the beginning of April.

That kind of increase in yields isn't good for the overall market, of course. But it's especially bad for sectors that are perceived as vulner-able to higher rates--banks, brokerages, utilities, and consumer lenders, to name a few. On the other hand, consumer-staples stocks like Procter & Gamble (PG, $105) (see story this issue) and Colgate-Palmolive (CL, $56), as well as health-care and energy stocks, tend to perform better when rates are going up. "If you look at 1994 again, financials and manufacturers of discretionary items took a hit, while consumer staples did well," says Wyss. "Very few people borrow money to buy shampoo."

Rival market seer Tobias Levkovich of Smith Barney isn't so sure Wall Street will follow the 1994 playbook. "The conventional wisdom is that once the Fed raises rates by a quarter, stocks will rally," says Levkovich, who's more bearish about the second half of the year. "But this market has been anything but conventional." News of stronger economic growth this spring should have pushed stocks higher, says Levkovich. Instead it has hammered the averages. Conversely, falling rates in 2001 should have been a boon--but in 2001 the S&P 500 fell 9.3%. Even so, Levkovich's picks echo many of Wyss's conclusions. He's advising clients to avoid banks, automakers, tech, retailers, and utilities. And Levkovich likes energy stocks, along with food and beverage companies, and makers of consumer staples. He also points out that mega-cap stocks are cheaper relative to the market than they've been in years.

Gurus in three-part harmony don't guarantee a stock market win, of course, as anyone who remembers the tech bubble can tell you. But it's worth noting that Merrill Lynch chief quantitative strategist Rich Bernstein is also recommending consumer and energy stocks, highlighting names like P&G, Altria (MO, $49), Exxon Mobil (XOM, $43), and ChevronTexaco (CVX, $92).

If rates, oil, and Iraq dominate the market in the short term, what's likely to move stocks later in the year? Besides earnings growth--and analysts' expectations for profits have been rising steadily --the other major uncertainty is the election. Although most observers say Wall Street favors Bush because of fear that Kerry will reverse the Bush tax cuts, the truth is that the Street just wants the election to be over. "They hate uncertainty more than they hate Kerry," says Wyss. "Post-election, I think there will be a year-end rally." No doubt that's something both candidates would be happy to support.