(MONEY Magazine) – As soon as Republican presidential nominee Bob Dole embraced tax cuts as a central theme of his floundering campaign, many economic commentators started bad-mouthing the plan as voodoo economics. A return to Reagan-style tax cuts, they argued, would swell the deficit, would push up interest rates and could well tip the economy into recession. And that, of course, would mean losses for investors.

Just let those pundits chatter. Tax cutting will likely be on the agenda no matter which candidate goes on to win in November. If the idea catches on with voters--and you can bet it will--President Clinton will push his own middle-class tax-cut proposals even harder.

Fortunately, the conventional negative view of tax reductions is flat-out wrong when it comes to stocks. Just consider these facts:

--Following Ronald Reagan's 1981-83 cuts in individual tax rates, the Dow Jones industrial average soared 48% and long-term interest rates plummeted four percentage points by mid-1986.

--John F. Kennedy's 1963 tax-cut proposal, which Lyndon Johnson signed into law in 1964, contributed to the Dow's 19% gain over the next two years.

--Reductions in the effective capital-gains tax rate in both 1978 and 1981 helped boost stock prices as much as 25% within two years.

We're not naive enough to accept the supply-side theory that tax cuts pay for themselves. That notion really is voodoo. In fact, the extra growth generated would likely make up for only 25% to 40% of the revenue lost, according to Nobel laureate economist Gary S. Becker.

Nonetheless, for two to five years, tax cuts are generally positive for stocks because they enhance growth. Many commentators would tell you stocks have nowhere to go because the economy is already expanding as fast as it can without boosting inflation. We're more optimistic. Currently, the U.S. is using two percentage points less of its total manufacturing capacity than it was in 1994. That suggests there's at least a little room for additional growth.

The increasing likelihood of tax cuts doesn't change our basic forecast. We still think it's likely that stock prices will start to decline before year-end and that the Dow could fall below 4900 within the next nine to 12 months. Reason: The economy is already heading for a temporary slump.

Such a slowdown would allow long-term interest rates to fall to 6%, from more than 7% today, producing double-digit total returns on long bonds. "We expect bonds to outperform stocks for the next 12 months," says Richard F. Hokenson, chief economist at Donaldson Lufkin & Jenrette in New York City.

Beyond 1997, the prospect of tax cuts only reinforces our positive outlook. In our view, the combination of low inflation, moderate interest rates and a rebounding economy figures to propel the Dow to more than 8000 by the year 2000 even without lower tax rates.

Your smartest strategy now is to look for bargains, such as the stocks in the story on page 120. In addition, the Wall Street Newsletter on page 69 assesses the earnings outlook for the 25 most widely held stocks.

Stick with defensive stocks such as these, consider adding to your holding of top-quality bonds, and build your cash reserves to as much as 25%. That way, you'll be perfectly positioned to profit when the stock market gets ready to roll again in a year or so.

ALL DATA AS OF SEPT. 3

Wall Street editor Michael Sivy is a chartered financial analyst and a former Wall Street research director.