(MONEY Magazine) – We won't know for months whether the recession has officially ended, but it seems that folks all over Wall Street are high-fiving one another over the turnaround. Since September, Standard & Poor's 500-stock index has soared 18.5%. In March, the Dow Jones industrial average recorded two of its biggest one-day gains in the past two years.

Nearly every new piece of economic data has beaten expectations. The economy grew 1.4% in the fourth quarter, more than two percentage points above estimates. Unemployment came in at 5.5% for February, short of the 5.6% rate many economists had predicted. "The recent evidence," Fed chairman Alan Greenspan told the Senate banking committee in early March, "increasingly suggests that an economic expansion is already well under way."

No one can predict how this recovery will play out, but almost everyone we spoke with says the rules for playing the rebound have changed. "This recession was really an investment bust and a bust in the stock market, so the recovery is going to be very different than in the past," explains William Dudley, chief U.S. economist at Goldman Sachs. That means business spending, not consumer spending (which accounts for two-thirds of the American economy), will drive the next phase of growth.

In previous downturns, it was personal consumption that cratered. Not this time. Drastic rate cuts by the Fed--11 in 2001 alone--strengthened the housing and auto markets, and last summer's tax cuts put money directly into people's pockets. That helped buoy retail, auto and housing (industries that typically lead coming out of a recession) long before the economy turned. There was no such reprieve for corporate America. Businesses slashed inventories by 6% in 2001, the largest liquidation in postwar history. Meanwhile, earnings growth for the S&P 500 declined 20% and capital spending fell off a cliff.

Now, companies are ramping up production--inventories rose in January, the first increase in a year--and most analysts predict that S&P 500 earnings will grow 10% this year and 11% next year. But capital spending will lag, depending on how much overcapacity each industry created during the boom--a challenge for telecom and tech. "The economy is in full swing now," says fund manager Mario Gabelli, "but not all cylinders are hitting."

The market has already sensed a recovery, bidding up economically sensitive stocks like industrial cyclicals. Chipmaker Texas Instruments is up 52% since September; aluminum producer Alcoa, 33%; and railroad giant Norfolk Southern, 69%. There are few bargains left among the early leaders, so the best way to play the recovery now is to look for good, stable growth stocks that stand to get a boost from the cyclical rebound but also should benefit long term from sustained economic strength. Here are eight stocks and five mutual funds to start you out in this new market.

Banking on a bounce

Last year was a bust for investment banks. Activity in the two most lucrative fields--mergers and acquisitions and initial public offerings--fell around 50%, while earnings at top investment banks tumbled an average 33%. But as the economy perks up, so will capital markets. (In the first three months of the year, 42 IPOs had been filed, more than in the previous two quarters combined. See page 32.) That's good for Goldman Sachs (GS), which gets 24% of its revenue from investment banking and leads the industry in M&A and IPOs. At a recent $89, Goldman commands a premium P/E of 19.9, but rightly so, since its profits should accelerate more rapidly than competitors' as a new bull market plays out.

For a more diversified play, try Morgan Stanley (MWD). While investment banking accounts for 16% of Morgan's revenue, asset management provides another 19%--and asset management is an especially fast-growing business, thanks to Morgan's 13,500 brokers, second in number only to Merrill Lynch. Recently trading at $57, Morgan Stanley looks to us like the best bargain in banking. Its 2002 P/E is 16.7, or a 16% discount to Goldman's P/E. And its earnings are expected to grow 17% in 2003, compared with a 7% gain this year. Says Raymond McCaffrey of PBHG Large Cap Value: "Long term, they're going to be one of the big players."

Energized earnings

Energy stocks didn't stand a chance in 2001, and not just because of the Enron disaster. Plummeting prices and mild weather did real damage too. "Last year was the perfect negative storm," says CSFB equity strategist Tom Galvin.

But prospects look sunnier lately. Oil prices are up more than 45% this year. And unlike other sectors, energy is not suffering from a capacity glut. Refineries were operating at 90% to 95% capacity, despite the warm winter and the recession. "A global recovery means more demand, especially from Asia, which is more manufacturing-intensive," says Patrizio Merciai, chief strategist at Swiss investment bank Lombard Odier. As demand picks up, drillers like Diamond Offshore (DO), $31 a share at the end of March, should see revenue gains, as should companies like Weatherford International (WFT, $48) that sell equipment to drillers. A more conservative pick: ChevronTexaco (CVX), which is up 6% since we profiled it in our January issue as one of the best investments for 2002. Earnings fell 17% last year, but as demand rises, Chevron, at $90, could easily surprise Wall Street. Plus, it expects to wring nearly $2 billion in cost savings from its 2001 merger. With a P/E of 23.9, Chevron trades at a discount to ExxonMobil (P/E of 24.8). Toss in the 3.1% dividend, the highest of the major oil stocks, and Chevron is a good deal.

Healthy growers

We're only at the beginning of this recovery, so it's too early to tell which sector will take the lead in any bull market. But we think it'll be hard to trump health care over the long haul. "I think it's the only sector where the pricing power will continue to exceed inflation and where growth is likely to beat GDP," says CSFB's Galvin. Analysts see earnings growing 16% annually over the next five years. "There's long-term trend support for health care," says Allen Sinai of Decision Economics, citing demographics and innovations.

A pharmaceuticals maker like Merck (MRK) and a medical equipment manufacturer like Medtronic (MDT) should do well in the long run. And both are now decently priced. At $57 a share, Merck's current P/E of 18.3 is 37% lower than its five-year average. Medtronic, at $44, trades at an 18% discount to its historical P/E.

But we especially like Cardinal Health (CAH, $71), the largest drug distributor in the country. Its earnings are less dependent on product cycles and blockbuster drugs--Cardinal makes money regardless of whether Merck or Pfizer has the hot allergy medication. As a result, Cardinal's earnings are sweetly consistent: Profits have grown at least 19% annually for the past 13 years. Still, at 26.8 times earnings--an 18% discount to its historical P/E--Cardinal Health remains a good value, especially with projected annual earnings growth of 20% over the next five years. "Once you get into a sustained rally," says portfolio manager Rick Drake of ABN AMRO/Chicago Capital Growth, "stocks like Cardinal Health with solid, consistent growth are going to do well."

Small-caps, high yields--and more

If history is any guide, high-yield and small-cap funds should be among the best performers during the rebound. Since the 1940s, high-yield corporate bonds (also known as junk bonds) have beaten long-term government bonds in the 12 months following a recession. Small-cap stocks tell a similar story, posting average gains of 39.2% in the year after the end of a recession vs. 25.1% for the large-cap S&P 500.

Pioneer High Yield remains one of the top junk picks (see our profile of Pioneer manager Margaret Patel on page 38). For a more traditional offering, try T. Rowe Price High Yield (800-638-5660). Over the past decade, the bond fund has returned an annualized 7.3%, placing it in the top 16% of its peer group.

On the small-cap side, we suggest Schroder U.S. Smaller Companies (800-464-3108). Manager Ira Unschuld stocked this growth fund with a good dose of rebounders last year, such as the asset-management shop Federated Investors, restaurant chains Applebee's and Ruby Tuesday and software company Symantec. In the past three years, the Schroder fund has returned an annualized 23%, outpacing nearly 90% of its small-cap-growth peers. If you want a more moderate offering, try T. Rowe Price Small-Cap Stock (800-638-5660), which offers a tamer mix of both value and growth stocks.

For broader exposure to the market, take a look at Gabelli Asset (800-422-3554). Mario Gabelli has seen plenty of economic cycles in his four decades in the stock-picking business, and he began positioning the fund for a recovery nearly a year ago. There's a big batch of economically sensitive stocks, such as mid-size media companies that should profit when print and broadcast advertising pick up again. "Pulitzer and Paxson Communications will benefit from a cyclical recovery," says Gabelli, "but they also will likely benefit from mergers down the road with other media companies." M&A activity could also bode well for Gabelli's picks in the utility and telecom sector, both of which are expected to see waves of consolidation going forward.

And the man's record is stellar. In the past five years, Gabelli Asset has posted annualized gains of 14.9%, a good 4.5 percentage points higher than the typical midcap blend fund. That makes Mario a great choice--regardless of the economic outlook.