(MONEY Magazine) – Here's a pop quiz: In the past 12 months, which of the following have occurred? a) a bear market b) currency crises in both Russia and Brazil c) the impeachment of the President of the United States d) the near meltdown of the international monetary system following the collapse of a huge hedge fund e) a 1,600-point rise in the Dow industrial average.

The answer, of course, is all of the above. And given events a-d, the fact that the Dow isn't 1,600 points lower than it was at the time of our last midyear investment guide suggests that either the stock market is indeed floating inside a giant bubble or that there's something to this New Era of low unemployment, low inflation, increased worker productivity and higher stock valuations.

Which conclusion is correct? Smart people can make good arguments for either, and in truth we think the stock market deserves to be valued above historical norms now--though perhaps not this far above them. But what the Dow's and the S&P 500's strength shows is that trying to forecast the market's near-term direction is very difficult, and ultimately pointless.

That said, we've been seeing caution signs that we believe dictate a strategic adjustment in many investors' thinking: First, stock prices have continued to rise much faster than earnings--New Era or not, that can't go on forever. Second, the market appears confused. One month inflation worries spook investors; the next month all is well. Long-depressed, small-caps and cyclical stocks now show hints of toppling technology stocks as the market's leaders. Internet stocks are getting ever more volatile. And finally, traders seem to lack conviction. Volume is light as the Dow drops 140 points one day and climbs 160 the next. (See "A Picture of the Market at Midyear" on the facing page.)

Those factors and others have us thinking defensively, especially when it comes to the stocks of the large, fast-growing companies that have powered the S&P to its extraordinary 26% annualized return over the past five years. But we're hardly advising a full-scale, sell-and-get-out retreat. This market's Nifty Fifty could crank out high returns for years. Rather, we suggest a return to principles that have been too often ignored in recent times: It's better to buy at low valuations than to chase high-priced stocks and hope to bail before they fall; you want to take advantage of the market's funks, not get sucked into throwing money at its manic rises; it makes more sense to position your portfolio to withstand turbulence than it does to bet all on New Era thinking.

These principles always make sense, but they're especially important now, when the returns of big stocks have likely concentrated an outsize portion of your net worth in expensive holdings that would be most vulnerable in a downturn. (See page 76.)

How do you act on these principles? We have a four-part strategy:

1. CONSIDER TAKING PROFITS ON INVESTMENTS THAT HAVE SOARED. In our May issue we urged Internet investors to sell some of their shares. That call proved prescient, as Net stocks took a hard fall soon after. Now we think you should look at your entire portfolio and consider selling portions of your big winners, especially if they're in tax-advantaged accounts or you've got losses in other investments to offset your gains. You might, for example, take your original stake off the table from investments that have doubled or tripled in the past two years--if you're going to keep playing, do it with house money.

2. DON'T BE SHY ABOUT LETTING CASH BUILD UP. That's the strategy favored by MONEY Wall Street editor Michael Sivy. (See his bearish column on page 33.) We're not market timers, but we do believe that today's high valuations should make you cautious about putting large amounts of new money into stocks. We don't often recommend staying out of the market, but if you aren't comfortable buying today, don't force yourself.

Ironically, the force behind the updraft in stock valuations--the Internet--has also made cash more appealing. As you can see on our savings tables, page 112, Web banks are paying more than 5% on money-market accounts, over twice the national average. A nonWeb bank, Capital One (800-564-7426), has the best deal this month--5.26% on deposits of $10,000 or more.

3. RESTORE SOME BALANCE TO YOUR PORTFOLIO BY BEEFING UP YOUR BOND STAKE. For most investors, the Vanguard Total Bond Market Index fund is the way to go. The fund has achieved steady returns in recent years (averaging 7%) with minimal credit risk and minuscule fees. Or you can guard against inflation by purchasing inflation-indexed Treasury bonds, which have their principal adjusted periodically for increases in the consumer price index. A handful of funds, including Pimco Real Return Bond, specialize in such bonds. (For details, see the table on page 72.) You can also buy them directly from the government by setting up a TreasuryDirect account (www.treasurydirect.gov).

4. LOOK TO BUY STOCKS IN AREAS THAT ARE UNDERVALUED--AND MOST LIKELY UNDERREPRESENTED IN YOUR PORTFOLIO. Our recommendations, discussed below, include two large growth stocks that have hit temporary slumps and three attractively priced issues that are good defensive investments in the event inflation returns. Finally, we'll recommend six mutual funds that will give you exposure to small-caps and international stocks. We'll also take a look back at our January recommendations for 1999's best investments. Now on to our stock and fund picks.

FALLEN GROWTH STOCKS

There aren't many stock strategies we like more than buying good growth companies when the market overreacts to bad news. One of the best examples in recent history is Cisco Systems. In the spring of 1997, Cisco shares fell by a third to about $10 (adjusted for subsequent splits) as investors worried about increasing competition and the possibility of a recession that would slow down spending on data networks. Two years later, we know the economy and network spending accelerated and that Cisco grabbed the lion's share of the market. And Cisco shares now change hands for $60.

With that in mind, we went to our computer database and screened for large companies (more than $10 billion in market capitalization) that have stock prices off a third or more from their 12-month peaks and estimated long-term earnings growth of at least 10%. The stocks also had to have price/earnings ratios below the S&P 500's average of 26, based on estimated 2000 earnings. Our computer spit out 12 companies. All are undervalued on the numbers, but some--including Compaq (recommended in our July issue), Philip Morris and J.C. Penney--face significant long-term challenges. We were drawn to two specific stocks, both of them fast-growing, brand-name companies that investors have punished too harshly for temporary problems.

ALLSTATE PRICE: $35.50 P/E: 10

Unless there's a hurricane or earthquake, property and casualty insurance is usually pretty boring. Not last year. Direct-to-the-consumer auto insurers such as Progressive and Warren Buffett's Geico slashed prices, pressuring agent-based companies like industry leaders State Farm and Allstate. The price war hit Allstate especially hard because it had sold all of its commercial and reinsurance operations by 1997, tying its fortunes to cars. Allstate's share price fell by a third to $35.50, where it's languishing (State Farm is a mutual company whose stock isn't traded).

Newly installed CEO Edward Liddy is looking for ways to extend the Good Hands People's reach. The company's 15,000 agents are a formidable force, but they sell only Allstate products. Thirty percent of all personal insurance ($45 billion in premiums) is sold through independent agents. In a bold move this spring, Liddy bought CNA's property and casualty unit, which generates $1.7 billion in premiums and includes a network of 3,800 independent agents who have close relationships with CNA but also sell other lines.

"The CNA acquisition gives Allstate a second distribution channel," says David Schafer, manager of the Strong Schafer Value fund, who has been buying the stock recently. The deal makes Allstate the third biggest independent broker and positions it to grab more market share. And its strong back office should improve CNA's profitability. Plus, says CEO Liddy, the extra premiums will allow Allstate to take advantage of economies of scale. "If you increase the size of the business by running more policies through our processing, claims and technology centers," he says, "then each transaction costs us less, and we can offer better rates."

Northbrook, Ill.-based Allstate sells for 10 times estimated 2000 earnings, which is at the low end of its historical range. The company's strong brand and industry-leading operating skill deserve better.

MATTEL PRICE: $24.50 P/E: 13

Mattel could have used a Crisis Prevention Barbie last year. Inventory reductions at Toys R Us and other retailers caught the toy giant completely off guard in the critical Christmas season; investors abandoned its shares the way a toddler discards a broken toy. It's no wonder. After the company had missed Wall Street's profit projections for its second and third quarters, CEO Jill Barad set high expectations for Christmas. But again all she could deliver was bad news, as fourth quarter earnings came in 67% below the previous year's. The stock hasn't recovered yet, and it currently trades at around $24.50, 45% off its 52-week high.

But Mattel is getting its dollhouse in order. To tackle inventory problems, the company is requiring customers to place orders in full before Thanksgiving. That will allow Mattel to match production with declared demand rather than guess how many units a client will eventually want.

The company is also trying to cut its dependence on Toys R Us and Wal-Mart, which together account for more than 30% of revenue. Last year it bought the Pleasant Company, which owns the American Girl doll brand, sold primarily via direct mail. Mattel this spring picked up the Learning Company, the world's second largest consumer-software publisher, which also sells directly to consumers. And in the fall it plans to launch Mattel.com, its e-commerce arm. "The next 18 to 24 months could well see the emergence of a new Mattel," says analyst David S. Leibowitz of Burnham Securities.

At a P/E of 13, the stock has attracted bargain hunters. "That's too cheap for a company of this quality," asserts Kevin Grant, an analyst for the Oakmark funds at Harris Associates, which owns 6% of Mattel's stock. We agree.

INFLATION PLAYS

Signs of rapid economic growth this spring sent investors looking for "defensive" stocks, those that perform better during inflationary times. Though fear of an imminent sharp upturn in prices has waned, it's also true that the U.S. economy keeps performing better than expected, and more economists than not predict the world economy will improve. With that in mind, we asked Wall Street strategists to suggest underpriced stocks that will get a boost from strong economic growth and perform well should inflation really return. Some numbers crunching on our part, plus additional interviews with the strategists, money managers and analysts, led us to our three choices.

PROCTER & GAMBLE PRICE: $85.25 P/E: 26.8

The rationale for buying a consumer-products giant like Procter & Gamble in an inflationary economy is simple: "You don't stop doing laundry just because interest rates are higher," says Morgan Stanley Dean Witter analyst James Dormer.

But there's more to the P&G story than Tide. In June, CEO Durk Jager announced a long-overdue restructuring, cutting 15,000 jobs and $900 million in costs. In his first year on the job, he has streamlined the company's product development process. It took 13 years to move Pampers from concept to market, says P&G spokesman Simon Denigree, compared with two years for the new Swiffer dry-mop. "We were very sequential before," he says. "Now we're doing simultaneous test-marketing around the world and launching products globally."

Strong Equity Income fund manager Rimas Milaitis says P&G's P/E of 25, based on his optimistic estimates of next year's earnings, looks cheap compared with the 31 multiples of Colgate, Gillette and Estee Lauder. "If I didn't own it, I would build a position at this level," he says.

Though revenue growth has been a sluggish 3% for the past few years, the company expects to double sales over the next decade through acquisitions and by entering new categories with products like fabric freshener Febreeze and in-home dry cleaner Dryel. Morgan Stanley's Dormer thinks the stock can hit $110 in the next 12 months, up almost 30% from its current price of $85.25.

DUKE ENERGY PRICE: $55.25 P/E: 14.4

There are good reasons to think about utilities now: Energy consumption increases in prosperous times, and the industry has pricing power should inflation spike up; utilities' high yields can give investors some protection in a market downturn; and the consolidation and deregulation of the industry creates opportunities for the strongest players to boost their earnings growth rates.

If you want a combination of defensive characteristics and potential growth, look no further than Duke Energy. It yields a respectable 3.75% and it's the nation's second biggest utility, so it offers the kind of liquidity that institutional investors seek in a market scare. Duke jumped $6 a share to $58 when investors got nervous about inflation in May.

But North Carolina-based Duke also offers an expected earnings growth rate of 8% to 10%--double the industry average. That's because as electric and gas producers have been deregulated, Duke has been snapping up other utilities and going into new lines of business. "The removal of regulatory constraints has been the driver of this industry," says CFO Richard Osborne. "We now have a lot of upside potential in our business."

Duke's push started two years ago when it merged with Pan Energy to become the nation's biggest producer of natural gas. Other gas buys followed. Recently Duke has diversified into telecommunications and real estate as well.

The stock's 14.4 P/E is 10% higher than the average electric company's. But Duke's premium has historically been double that. Investors are taking a wait-and-see attitude toward the company's recent acquisitions, says Merrill Lynch Global Securities analyst Steven Fleishman. He notes that so far Duke is hitting earnings expectations.

With the growth from those new businesses, First Union Capital Market analyst Thomas Hamlin expects the stock to climb 27% to $70.

SMURFIT-STONE CONTAINER PRICE: $19.75 P/E: 11.7

Commodity stocks have soared in recent months as the nascent global recovery increases the chances that growing demand for their products will allow these companies to raise prices--finally. Alcoa, for example, is up 52% since we recommended it in our March issue and Dow Chemical has jumped 43% this year.

Paper stocks have also risen, but we think some of them have plenty of room to run. First, box makers should do especially well in prosperous times. As Charlie Ober, manager of the T. Rowe Price New Era fund, notes, "Every export has to be shipped in boxes." Second, these companies are cutting capacity. The box company we like best is Smurfit-Stone Container Corp., the No. 1 maker of corrugated cardboard.

Created by the November merger between rivals Jefferson Smurfit and Stone Container, the company has been simplifying its corporate structure and shedding assets. It has closed the doors at four of its 23 mills and six of 126 plants. "We're meeting goals and objectives by taking out inefficient mill capacity," says Thomas Lange, a spokesman for the Chicago-based company. "They've done a lot in self-help," agrees Ober, who has 1.1% of his fund's assets in Smurfit-Stone.

Merger and shutdown costs have depressed results so far this year; analysts expect the company to make money again next year. The stock popped 30% in April, before sliding back a bit to a recent $19.75. Deutsche Bank BT Alex. Brown analyst Mark Wilde sees it reaching $35 within a year. "It's just a matter of time before economies pick up in Europe and Latin America, where they are the largest sellers of containerboard," says Wilde. An expected industry-wide price hike at the end of summer, he says, should also boost earnings.

SMALL-CAP FUNDS

You can't blame investors for ignoring the stocks of small companies--they've lagged the market for five years. But now they're showing signs of life. Since April, the S&P 600 small-cap index has gained 11.3%. But even with that rebound, small stocks trade at a P/E of 20.3 based on 1999 earnings estimates, a third less than large-caps sell for. Plus, analysts are anticipating that small companies will put on a good show when second-quarter earnings come out.

Because small-caps often move to a different beat than big stocks, financial planners recommend keeping at least 10% of your assets in them for diversification. A lack of information, however, makes researching single issues a full-time job. That's why we prefer mutual funds. We profile three small-caps and one midcap below. All are members of the MONEY 100, our annual ranking published in June of the world's best funds.

BERGER SMALL CAP VALUE ANNUALIZED RETURN SINCE INCEPTION: 18.4%

In 1985 Robert Perkins, then a fund manager at Kemper, started a private fund with 34 business acquaintances who each invested $100,000. After the group's stake had grown tenfold, the partners sold out in 1997 to Denver fund company Berger. Perkins kept running the fund, and today Berger Small Cap Value is one of the best-performing funds in its class.

Perkins likes stocks that have been knocked 50% off their highs because of problems that he thinks can be corrected within six months. This often means buying yesterday's hot growth stocks. In 1997 Perkins went shopping in the semiconductor industry. Last year he bought up cheap telecommunications equipment businesses. Today he's hot on information technology firms working on the Year 2000 computer bug; they sold at up to 60 times earnings when the market loved the idea that companies were spending tens of billions of dollars to make sure their networks didn't lock up come Jan. 1. But now that such spending is winding down, some Y2K stocks are a sixth their former price. Recent buys Computer Horizons, Interim Services and Romac International all have a new mission: helping retailers move into e-commerce.

FREMONT U.S MICRO-CAP THREE-YEAR ANNUALIZED RETURN: 17.4%

Manager Bob Kern shops for very small stocks, those with less than $500 million in market cap. "There are just so many microcaps, and few analysts follow them," Kern says. "If you hope to add value through research, this is the place to do it." Kern's knack for finding winners before Wall Street catches on has put his fund in the top 10% of all small growth funds over the past three years.

Kern seeks out firms that can increase earnings 20% a year no matter what the economy does. So it's no surprise that technology is prominent in the portfolio. The fund's stake in Internet start-ups is minimal; Kern prefers indirect Net plays like Orckit Communications, which makes high-speed digital modems, and HI/FN, a semiconductor company that specializes in encryption.

OAKMARK SELECT ANNUALIZED RETURN SINCE INCEPTION: 38.7%

If the thought of pulling your money out of large-caps and plunking it into risky small companies makes you woozy, you can take the middle road. Midcap Oakmark Select is a young fund, opened November 1996, run by seasoned stock picker Bill Nygren. Although Nygren isn't restricted to mid-size stocks, that's where he's finding value now.

Like other Oakmark managers, Nygren sorts through a list of about 100 ideas generated by in-house analysts. Rather than setting strict limits on P/Es, Nygren considers where a company is trading relative to its industry and to what it could fetch in a private sale. Recently, for example, he bought shares in Times Mirror, publisher of the Los Angeles Times and Newsday, at what he considers half the theoretical takeover price. "It was trading at seven times cash flow, and most acquisitions of newspapers are at 15 times cash flow," he says.

Nygren likes to hold fewer than 20 stocks, and half the fund's money can be in its five biggest positions. "We think our real skill is in stock selection, and we want to maximize impact," Nygren says. That concentration increases volatility, but the fund can add zip to a portfolio of index funds. So far in 1999 the fund is up 17.3%.

VANGUARD SMALL CAP INDEX THREE-YEAR ANNUALIZED RETURN: 11.3%

As for index funds, if you want to get your fix of small-cap stocks in a low-cost way, the Vanguard Small Cap Index is hard to beat. The fund, which tracks the Russell 2000, has averaged 15.8% gains over five years, outdoing 62% of all small blend funds over that time. Low turnover, a feature of all index funds, makes the fund relatively tax efficient, while its 0.24% expense ratio is a bargain.

INTERNATIONAL

Why leave home? It's a question that many investing pros are divided over, even titans like John Bogle, senior chairman of the Vanguard Group, and Burton Malkiel, author of A Random Walk Down Wall Street. Malkiel thinks international holdings can reduce a portfolio's overall volatility. Bogle says the risks of overseas markets aren't worth the possible benefit. But if the jury is out on the virtues of international diversification, it's undeniable these days that some of the best stock bargains can be found abroad. Here are two ways to play, the first considerably tamer than the second:

CAPITAL WORLD GROWTH & INCOME THREE-YEAR ANNUALIZED RETURN: 19.1%

One way to ease into international investing is via a world stock fund that can invest some of its assets in the U.S. Over the past five years the Capital World Growth & Income fund has outperformed 90% of all world stock funds and done so with less volatility. In 1998 it was up 16% as market shocks hit around the world. The fund has a 5.75% sales load, but its 0.78% expense ratio is half that of the average international fund.

Like all members of the American Funds family, this one is run by a team of portfolio counselors who each have a slice of the pie. (Another piece is divvied up among more than 20 analysts.) All managers adhere to a blue- chip, buy-and-hold strategy and follow a value approach, though they may define value differently. They aren't limited by region or sector, but the fund cannot invest more than 40% of its assets in any one country. Recently Europe and the U.S. each accounted for 30% of assets, Japan, 4%.

TEMPLETON EMERGING MARKETS THREE-YEAR ANNUALIZED RETURN: 7.9%

If you want pure international exposure--and can stomach the considerable risk--emerging markets offer the greatest potential. Stocks in Latin America, for example, are trading at half the price of those stateside.

Templeton's Mark Mobius wrote the book on this volatile sector. Mobius travels more than 200 days a year, crisscrossing the globe in search of undervalued companies. He's beaten his competitors every year since 1995, but even for him that has meant some years of double-digit losses. We told you this isn't for the faint of heart.

Mobius spent much of late 1998 looking for stocks in Thailand, Singapore and South Korea. "Now we're enjoying the benefits of those investments," he says. Earlier this year, he upped his stake in Latin America after Brazil devalued its currency. "On a global basis, telecommunications companies and banks in Latin America are cheap," he says. This closed-end fund trades at a premium to its net asset value, but Mobius may be worth it. The fund is up 37.3% so far this year.

Additional reporting: Kyra Alford and Ethan Johnson