(MONEY Magazine) – The long-term outlook for the U.S. economy is little short of brilliant: Inflation is low, workers' productivity is soaring, and U.S. companies are more competitive than they have been since the 1960s. But there are also reasons for investors to be on guard: Stocks are overpriced right now, and the economy is poised for a temporary slowdown that will reduce corporate profit growth from 12% or more to single digits. As a result, shareholders are edgy and every scrap of bad news seems to trigger at least a brief sell-off. So over the next 12 months, you can expect to feel as though you're on a seesaw with a bear, with the Dow figuring to plunge as low as 7000 and rebound as high as 8500. But if you take advantage of temporary downswings to buy first-rate stocks and mutual funds, you can come out on top when stocks resume their long climb.

Specifically, this is what we see ahead:

The economy. Growth will slow to an annualized rate of 2.5% by late 1998, down from 3.7% this year.

Inflation. Consumer prices will rise a tad faster next year than they did in '97, but inflation will remain well below 3%.

Short-term interest rates. By late '98, the slower economy will persuade inflation-obsessed Federal Reserve chairman Alan Greenspan that it's safe to lower short-term interest rates, and the 90-day Treasury bill yield will fall below 5%.

Bond yields. Long-term Treasury bond yields could decline nearly half a percentage point to 5.75% or less by the end of '98.

Corporate profits. Average earnings growth will slow to 7% next year, down from 12% in late 1997.

Stock prices. With the Dow likely to remain locked in a trading range, swinging sharply between 7000 and 8500, we see blue chips ending the year with a 7% price gain and small stocks up about 12% (see the chart on the facing page for our forecast total returns, including dividends and interest, for other types of investments).

Here's the thinking behind our economic outlook for 1998.

In the old days, from 1966 to 1982, the stock market followed regular patterns. In the five bull markets during that period, stocks as much as doubled from their lows. During those upswings, there were assorted corrections in which prices temporarily fell at least 10% before resuming their rise. And every three years or so, stock prices obediently retreated anywhere from 16% to 45% in bear markets generally lasting six months or longer.

For the estimated three-quarters of mutual fund shareholders who have invested the bulk of their money since 1982, however, such traditional patterns sound like the plot of a 1950s horror movie. Today the public is convinced that stock prices will rise steadily, that any pullbacks will be brief and that no recession will occur within the next three years.

It's easy to understand that optimism. Stock prices have grown a stunning ninefold since 1982 and have more than tripled since the fleeting 1990-91 recession. Almost every quarter, economic growth has been as much as two percentage points stronger than economists had estimated. Most striking, the Dow Jones industrial average climbed for seven years without a 10% pullback. (That magic time ended this fall, when the turmoil in Asia knocked the Dow down more than 13% from its Aug. 6, 1997 peak in October.)

As MONEY readers know from our 1996 and '97 forecast issues, we appreciate the long-term strength of the U.S. economy--but still think it's smart to be wary in this high-flying market. One big reason for our caution: As the chart on the facing page shows, stock prices rose more or less in line with corporate profits until early 1995. Then they sprinted up so rapidly that an unstable gap opened up between the Dow and the earnings of the companies that make up the index.

On the basis of that "earnings gap" and the growing possibility that the economy would slow, we've warned readers for the past three years that stocks could decline 15% to 20% before bouncing back again. So far, the market has defied those predictions. In last year's Forecast issue, we were correct that long-term interest rates would fall. But we were far off the mark predicting that economic growth would drop to 2% in 1997; instead the economy figures to expand 3.7%. And rather than returning the feeble 7% we expected, top-quality stocks gained around 24% in 1997.

Even so, it is clear that investors are getting increasingly edgy. In our August cover package "Sell Stock Now!," we pointed out that shares have become so overpriced that they are vulnerable to temporary price drops whenever a whiff of bad news wafts through Wall Street. "The more overvalued a market becomes, the more important money flows become, and they can turn on a dime if confidence is questioned," says investment strategist Elizabeth J. Mackay at Bear Stearns in New York City. And the stock dumping doesn't start with individual investors who shrewdly buy blue chips when the market dips and then hold for three years or longer. Rather, the sudden drops are usually initiated by panicky pros who have to beat the market averages every quarter to hang on to their jobs.

Only two weeks after our cover story hit the stands, the Dow peaked at 8259. And our warnings were confirmed over the next three months as the U.S. stock market plunged during the October turmoil in Asia. "Stock market volatility in October was almost twice as high as in any other month during 1997," says Melissa R. Brown, director of quantitative research at Prudential Securities.

That volatility doesn't figure to end, but the U.S. economy's robust growth continues to amaze us and other forecasters. With that performance as a backdrop, we believe that stocks remain the best choice for investors who want to accumulate wealth for retirement and other long-term goals, such as buying a home or paying for children's college tuition. Yet as we've noted, there are ample reasons for investors to be cautious--in particular, stocks are overpriced and the economy looks poised for a moderate slowdown. Therefore, your strategy this year should be to try to cash in on long-term growth while minimizing your chances of short-term losses that actually might scare you into leaving the market rather than riding out the ups and downs.

Here's a more detailed look at some of the factors that will sway the economy and the markets in 1998.

U.S. economic growth would be slowing even without the recent turmoil in Asia

The late-October collapse in the Hong Kong stock market helped drive the Dow down 554 points in a single day, largely because investors know the U.S. market is overpriced and worry that any bad news could spark a decline. But the striking fact is that collapsing stock markets and falling real estate prices in a handful of Southeast Asian countries won't have much impact in our hemisphere. The U.S. economy was likely to weaken in 1998 even before the Asian troubles began; they will simply be an additional drag. "Recent events in Asia will probably knock half a percentage point off of U.S. growth next year," says Merrill Lynch chief economist Bruce Steinberg. In addition, there's an important domestic reason for a slower economy: Increasingly nervous lenders are forcing overindebted consumers to slow their borrowing. Since 1995, growth in consumer credit (excluding mortgages) has slowed from a 15% annualized rate to less than 5%. Even so, the outlook isn't all that negative, says Steinberg: "Gross domestic product growth of 2.5% in 1998 isn't bad compared with a 3.7% gain in '97."

Moderately slower economic growth, in turn, will likely trim increases in corporate profits from 12% or so in '97 to single digits in '98. That slowdown could threaten many U.S. multinationals that have long enjoyed annual earnings growth of 12% or more because of their international expansion. "The overseas earnings of such U.S. subsidiaries have increased to about 30% of total profits in recent years, so a setback internationally would damage an important source of earnings growth, primarily for companies with exposure to Asia," says Prudential Securities chief economist Richard D. Rippe. As examples of vulnerable firms, analysts cite Boeing, Caterpillar and Citicorp.

INFLATION DOESN'T POSE ANY IMMEDIATE RISK FOR STOCKS

Underlying our forecast is our firm belief that, although inflation could pick up a little bit from its current 2.1% annual rate, it will remain well below 3% throughout 1998 (see the chart at left). "The broadest measures of inflation continue to decline," says Steinberg at Merrill Lynch.

Why are consumer price increases so low? Primarily because corporations lack pricing power. That's economistspeak for a company's ability to charge more for its products without losing sales. In addition to the corporate downsizing of the past 15 years, which has made workers more restrained in their wage demands, global competition has kept a lid on the cost of consumer goods. "Import prices have declined 3% over the past year, which has helped to hold down inflation," says Rao V. Chalasani, chief investment strategist at Everen Securities in Chicago.

This is what puts corporations in a profit vise. But even if little inflation shows up at the consumer level, companies will be faced with rising production costs. Growth in workers' average hourly earnings has been increasing since 1992 (see the chart at left). Much of that increase has been offset by some stunning, if sporadic, gains in productivity. In the third quarter of 1997, for instance, productivity rocketed up 4.5%, the strongest advance in five years. But if corporations can't raise prices and wages continue to rise--as we expect they will--sooner or later businesses will see profit margins shrink.

LONG-TERM INTEREST RATES ARE LIKELY TO FALL, WITH YIELDS DROPPING TO 5.75% OR LESS

The brightest spot in our economic outlook for 1998 is that interest rates are likely to fall. In 1994, Fed chairman Greenspan raised short-term interest rates nearly three percentage points. Although short rates have come down about half a point from their early 1995 high of 6%, they remain above normal levels, based on the current rate of inflation (see the chart on page 44). The reason: Greenspan has hesitated to lower rates significantly because he fears that rising labor costs will reignite inflation.

Testifying before the House Banking Committee in early October, Greenspan cautioned, in his usual polysyllabic manner, that continued rapid economic growth "must eventually erode the current state of inflation quiescence...." However, once economic growth slows to an annual rate of about 2.5%--as we believe it will in 1998--Greenspan could permit short-term rates to come down.

Rapid economic expansion has also kept long-term yields above their normal range. The chart on page 44 shows that bond yields generally range from two to 3.5 percentage points above the inflation rate of the previous five years. Once the economy slows, we would expect to see long-term yields decrease slightly as well, with yields on 30-year Treasury bonds falling as low as 5.75%.

CORPORATE EARNINGS GROWTH WILL AVERAGE ONLY ABOUT 7% IN '98

The effect of a slowing economy in the U.S. and overseas could hold blue chips' earnings gains to 7% in 1998, compared with recent annual increases of 12% or more (see the chart on page 45). Since at their recent average of 20, price/earnings ratios for blue chips were already near record highs, it seems unlikely that the average stock's P/E will increase, particularly in the face of a likely earnings slowdown.

Without P/E expansion, stocks can move up only as much as profits rise--a projected 7% as we see it. Add in current dividend yields of about 2%, and investors in blue chips would be likely to earn a total return (capital gains plus dividends) of only about 9%, just below the historical average for top-quality stocks. It appears unlikely, therefore, that the Dow would top 8500 or so next year. Moreover, any bad news--from a spike in inflation or interest rates to an unexpected shortfall in quarterly profits--could send stocks into a tailspin, knocking down the Dow as low as 7000 before prices rebound.

Now here's how to profit from the ups and downs:

YOUR BEST MOVES INCLUDE BUYING BONDS THAT COULD EARN 10% OR MORE

Although falling interest rates will help lift the prices of both stocks and bonds, slower corporate profit growth will limit stocks' gains. "Lower interest rates will be bullish for stocks but will boost bonds even more," says Edward Yardeni, chief economist for Deutsche Morgan Grenfell in New York City. "Bonds are likely to outperform stocks over the next two years even if the Dow goes into record territory."

If the Dow returns 9% in '98--as we are forecasting--bonds and other top-quality income investments could earn 10% or more. Electric utilities such as Atlantic Energy and Peco Energy could return as much as 28% and real estate investment trusts such as Associated Estates Realty and Health & Retirement Properties could turn in at least 15%. Most important, in the unlikely event of a serious economic slump that depresses stock prices by more than 15%, interest rates would fall even more sharply than we project. That, in turn, would boost bond prices and could produce returns of more than 15% on many income investments, which would offset losses on stocks in your portfolio.

ALSO, SMALL AND MID-SIZE STOCKS FIGURE TO OUTPACE BLUE CHIPS

In addition to including bonds in your portfolio, you should diversify among different types of stocks. In particular, you should be sure to include a sprinkling of small-company stocks among your holdings. Reason: Momentum now appears to be shifting away from blue chips to smaller issues. "In 1996 and the first half of '97, large-capitalization stocks were generating bigger earnings gains than smaller companies were," says market strategist Douglas R. Cliggott at J.P. Morgan Securities in New York City. "But big stocks' earnings advantage seems to have disappeared in the past few months."

Many strategists believe that small stocks--particularly those in industries such as technology and health care--will actually outpace blue chips in the next couple of years. For example, the story on page 78 profiles five small companies--such as Encad, a $210 million printer manufacturer, and Curative Health Services, a $114 million chain of outpatient clinics for the care of chronic wounds.

In the third quarter of 1997, small and mid-size stock funds returned an average of at least 14.5%, compared with only 7.3% for S&P 500 index funds, according to Lipper Analytical Services in Summit, N.J. Smaller stocks could continue to turn in market-beating numbers for two reasons: Many are relatively cheaper when you compare their P/Es to their growth rates than the highest-flying blue chips. In addition, they tend to be less exposed to economic problems overseas because a greater proportion of their profits are earned in the U.S.

CONSIDER AUGMENTING YOUR PORTFOLIO WITH ACTIVELY MANAGED MUTUAL FUNDS

When you're on a seesaw with a bear, indexing can backfire: You'll keep pace with the market, but if the market isn't making any overall progress, you won't either. Lipper found that index funds--unmanaged portfolios that hold a cross section of issues that make up popular stock indexes such as Standard & Poor's 500--have been exceptionally weak performers recently. In the third quarter, Lipper reports, index funds ranked dead last among eight major categories of U.S. stock funds.

Of course, there are very compelling long-term arguments for indexing: Over a decade or more, just keeping up with the market generally means you'll earn an attractive return. In addition, mutual funds that use indexing strategies generally have way-below-average annual fees, which can put them as much as a full percentage point a year ahead of the average managed fund.

Such predictability and low costs make stock index funds solid core holdings for at least 30% of your long-term money. However, during periods when small and mid-size companies are outpacing blue chips, it's smart to consider putting as much as half your equity money in actively managed mutual funds. For example, the story on page 54 spotlights six funds--including Clipper, Harbor International Growth and White Oak Growth--that focus on two or three dozen issues with the highest profit potential. The funds all have at least 45% of assets concentrated in their 10 top holdings.

DIVERSIFY BY FOCUSING ON THE BEST OPPORTUNITIES

Your foremost objective for 1998 is to ensure that you'll be in a position to ride out expected high volatility. To do that, you'll need to make sure your portfolio is as well diversified as possible. For starters, take a look at how much money you have in stock or equity funds. Because of soaring share prices over the past three years, you may be far more heavily weighted in equities than you realize. If you had 65% of your money in stocks in 1994, for instance, that stake may have swelled to more than 75% today.

You should take advantage of market upswings to unload some of your winners--particularly any stocks with price/earnings ratios above 25. Don't feel you need to reinvest that money in stocks right away. Instead, you should begin writing down a buy list of at least two or three dozen stocks you would like to own for the next 10 years and the prices at which you would be willing to buy each of them if the market were to break tomorrow. The story on page 60, for instance, discusses eight multibillion-dollar companies that look like excellent additions to your portfolio--including computer manufacturer Compaq, home-improvement-supply retailer Home Depot and copier maker Xerox.

A well-diversified portfolio should always include high-quality long-term bonds, such as Treasury issues maturing in 10 years or more, as well as cash reserves. In 1998, those income investments will be even more important than usual. Since bond prices rise when the economy slows and interest rates fall, keeping as much as 20% of your money in Treasury bonds or high-grade bond funds will help offset any stock market decline resulting from an economic slowdown that crimps corporate profits.

Similarly, keeping as much as 20% of your assets in money funds like $26 billion (assets) Vanguard Money Market Prime, recently yielding 5.5%, or some other cash investment will ensure that you have ample reserves to scoop up stocks on your most-wanted list if they temporarily dip to prices at which you are willing to buy them. The story on page 100 outlines the best income investments today. For full descriptions of all our top moneymaking picks for 1998, read on.