(MONEY Magazine) – Uncertainty continues to be the prevailing sentiment on Wall Street. While October was the best month for the Dow since January 1987, a recent survey by UBS and Gallup found that investor optimism is now at the lowest level since they began tracking it in 1996. And it's not just the markets that have proved to be stubbornly unpredictable. Corporate earnings and the overall economy, while showing improvement, never delivered the V-shaped recovery widely discussed a year ago. In fact, the unemployment rate edged higher in October, and businesses announced 176,000 layoffs, according to Challenger Gray & Christmas--the highest total since January. In addition, sales at the Big Three automakers tumbled more than 30% in October; however, that's measured against last October's performance--the strongest monthly showing ever.

If you're confused about the direction of this economy and this market, you're not alone. Actually, you're in very expert company. To sort out the mixed signals, we spoke with two highly regarded financial experts: William Dudley, chief economist at Goldman Sachs, and Edward Yardeni, chief investment strategist at Prudential Securities.

Goldman's Dudley believes the economy is going to be weaker for longer than many of his colleagues predict. He's looking for gross domestic product growth of not much more than 2% over the next two quarters. "We are most likely going to have a very sluggish period of growth, and the economy is going to be at risk of falling into recession," he says. "If there were a shock--for instance, if we have a war with Iraq and it goes badly and oil prices go up to $50 to $60 a barrel--that would probably be enough to take a very soft economy and push it into recession." However, Dudley says that while he thinks the odds of recession are pretty high right now, he would still peg them below 50%.

Why so gloomy? Dudley cites continued fallout from the stock market collapse of the past three years. "One, corporations interested in maximizing free cash flow are going to be reluctant to hire and reluctant to invest," he says. "Two, households whose net worth has taken a beating due to the weak stock market will probably try to save a little bit more out of their income. That, in turn, will restrain the pace of economic activity." The third factor is that state and local governments are going to have severe budgetary problems that he believes will become more evident over the next few months and may force them to raise taxes and cut spending.

Dudley also points to the strong dollar. "The consequence of the strength of the dollar," he says, "is that we're not really competitive in foreign goods markets. So the trade deficit is going to continue to deteriorate and that will also be a drag on the economy."

In terms of consumer spending, Dudley says there's no question that it's going to slow: "This third quarter was boosted by a sharp rise in auto sales that has since diminished." And he says he's "quite a bit more pessimistic" about capital spending than the conventional wisdom. He forecasts low capacity utilization rates, average return on capital and lower profit expectations--all of which, he says, imply that a capital-spending recovery will be much slower and longer in coming than people think.

Dudley believes corporate earnings are already recovering, but the problem is that earnings expectations going forward are still too high. "Companies are trying to cut their way to prosperity," he says. "That's fine if any one company tries to cut its costs--that can flow to the bottom line. But if companies collectively try to cut their costs and boost profits, all that happens is you end up having a weak economy and very sluggish growth at the top line."

Finally, Dudley says the economic impact of a war with Iraq all depends on the duration and success of the operation. "A favorable scenario would be a quick war that is successful in resulting in a regime change, which leads to an increase in Iraqi oil production and potentially lower oil prices," he says. "A much less benign scenario would be a war that might not be as successful...a war in which there were possible disruptions to oil supplies outside of Iraq, causing oil prices to go higher and stay higher. That would be a blow to an already pretty fragile global economy."

Ed Yardeni, Prudential's top investment strategist, is also worried about Iraq. "War is not inevi-table," he says, "but it seems extremely likely." While Yardeni says he has no doubt that the U.S. would win the war, he believes the real issue would be whether we'd win the peace. "A war with Iraq could either stabilize or destabilize the Middle East," he says. "Obviously, these two outcomes could have radically different impacts on the global war on terrorism and therefore the outlook for the stock market."

Yardeni says his bullish scenario for next year would require that the Iraq issue is resolved quickly and the Middle East becomes more, rather than less, stable. And, he adds, "one of the consequences of victory over Iraq--through either diplomatic or military means--is a big drop in the price of oil, maybe as low as $15 a barrel." That would represent a huge tax cut for consumers of oil around the world and could help provide a good lift to the global economy and to global earnings.

Overall, Yardeni calls himself guardedly optimistic, saying he's doing his best to stay positive on the long-term outlook for stocks, though there are reasons to be cautious about the near term. "There's a school of thought that believes we're in an environment where profits are going to remain very depressed," he says. "But I'm operating under the assumption that profits will recover." He points out that earnings were very disappointing this year--they were flat with last year's, and last year we had a very severe profits recession. But he thinks "we'll see a recovery in profits to $54 a share [for S&P 500 operating earnings] next year, up from about $48 a share this year."

Yardeni warns that there are still many investors who are worried about the quality of corporate earnings. "There's a lot of controversy about how we measure earnings," he says. "I think there are fewer concerns about widespread fraud in the reporting of earnings thanks to the Securities and Exchange Commission's Aug. 14 so-called truth-or-dare date [the deadline that the SEC sets for chief executive officers and chief financial officers to sign off on their corporations' financial statements]."

As for bright spots, Yardeni notes that in a bear market, "it's pretty hard to find anyplace to hide." But he says that earnings momentum is "really quite good" for consumer staples, home builders and housing-related retailers. He adds that it's also very good for many areas of health care, particularly managed care, hospital management, HMOs and medical-care devices, as well as some financials--especially those with a big presence in mortgage lending.

Reflecting the recent volatility in the market, Yardeni has changed his recommended asset allocations. For a moderately aggressive investor, he now suggests 10% cash, 25% bonds and 65% equities (from 30% bonds, 70% stocks). "I want to have a little bit less...in bonds and stocks, more in cash," he says, viewing that cash as a vehicle for trading in and out of stocks and bonds as opportunities arise.

Yardeni expects the S&P 500 index to finish the year around 900. He believes the index could reach 1100 by June if a possible war with Iraq goes well, resulting in lower oil prices and a stronger global recovery.

If a possible war with Iraq goes well... If corporate earnings finally show significant gains... If investor confidence in corporate leadership recovers...With so many questions still unanswered, it's not likely that uncertainty in the markets and the economy will be resolved anytime soon.

Lou Dobbs is the anchor and managing editor of CNN's Lou Dobbs Moneyline.