NEW YORK (Money Magazine) - We always urge investors to step back from the frenzy of daily market swings and consider the big picture. Trouble is, there is no big picture today.

Investors trying to figure out the stock market are faced with chaos and confusion. None of the standard investing benchmarks or historical patterns have offered much useful guidance since the stock boom began in the mid-1990s.

Special: Investing in 2003 What the gurus are saying now Best Stocks 2003 Yacktman: The guy who got it right

With so many crosscurrents, investors can't decide whether to overweight growth stocks in the hope of cashing in on a rebound or to favor conservative companies that have remained relatively untouched by the market's most recent slide. Some people may even be wondering whether they should own stocks and equity funds at all.

In fact, it is possible to devise a rational investing strategy. To do so, you have to start by recognizing that the current market simply doesn't make sense in terms of a classic business cycle. We're out where the trains don't run. You also need to consider individually each of today's important economic and market trends rather than looking for a grand pattern.

There are three key facts about recent market behavior that deserve consideration.

• First, stock prices began diverging from historical norms around 1995 -- and have become increasingly erratic since then.
• Second, the bear market that began in early 2000 has been far more severe and has lasted far longer than the economic slump that triggered it.
• Third, the stock market's biggest problems are far better publicized today than they were three years ago. This means that even though conditions actually have been slowly improving, they look worse.

I'm not sure that anyone can fully explain why the market cut loose from the economy in the late 1990s. Some of it had to do with all the excitement generated by the Internet and other rapidly developing technologies. The absence of a really bad recession after 1982 also encouraged many investors to become overconfident. And the money that poured continuously into 401(k) accounts gave investors the means to act on their exuberance.

Whatever the reasons for the market's destabilization, the fact is that share valuations soared to levels not seen since the Nifty Fifty market of the early 1970s. And just as it did 30 years ago, the run-up ended with a cataclysmic crash.

Bear markets can occur for three different reasons. First, share-price declines may simply reflect a downturn in the economy and corporate earnings. Second, excessive valuations can collapse, as they did for many growth stocks over the past three years. Third, misguided government policies or major bank failures can paralyze the financial system, causing a persistent slump like the one that has afflicted Japan since 1989.

The recent bear market has been more severe than the economy alone can explain. And there's clearly been a correction in stock valuations. But we haven't seen the pervasive problems in the economy that make for chronically depressed stock prices. Economic slumps almost always end within two years -- and corrections for overvalued P/Es rarely last longer than three.

If we don't have to worry about a financial collapse, then what other factors could keep stock prices down?

One current cause for worry is the notion that the United States is in the midst of a deflation. That's false by definition, since one key inflation measure, the GDP deflator, is rising at just over a 1 percent annual rate and consumer prices are climbing faster. Even so, Federal Reserve officials acknowledge that there is a slim chance of a downward price spiral within the next few years. Maybe so. But with money-supply growth topping 7 percent, it seems more likely that inflation will pick up.

If there is any real deflation, it will be because of some unanticipated shock. And indeed, there's no shortage of unpleasant economic and political possibilities to worry about nowadays.

But the extraordinary fact is that almost all of these risks have been reduced from what they were a couple of years ago, the threat of war with Iraq notwithstanding. Stocks are clearly less overvalued than they were at the start of 2000. Corporate scandals and fraudulent accounting are being investigated and cleaned up. And whatever the flaws of the current Homeland Security plans may be, we're doing more to stop terrorism than we were a couple of years ago.

So let's look at the economy point by point in order to see why the long-term outlook is fundamentally encouraging.

Consumer spending is the main engine of the U.S. economy, accounting for approximately two-thirds of gross domestic product. And consumers are in pretty good shape.

Despite layoffs, unemployment is holding on at around 6 percent. Pessimistic economists make much of the buildup of consumer debt -- and it's true that debt levels are at a peak. But that burden is more than offset by low interest rates. Consumer debt payments are still lower relative to income than they were in the early 1980s.

Moreover, thanks to high productivity -- which is rising at near-record levels -- labor cost trends get two thumbs-up. For workers, wages and salaries may be increasing more slowly than they were a few years ago, but they're still outpacing inflation.

For corporations, however, labor costs are declining because workers are more productive. And with lower unit labor costs, companies can boost profits even if sales aren't growing very fast.

The impact of mortgage refinancings can't be ignored either. Over the past couple of years, mortgage rates have fallen from above 8 percent to less than 6 percent. As a result, refinancings have soared to a record of more than $400 billion a quarter. And each household that refinances typically frees up $200 or so a month that can be spent on consumer goods and services.

The current economy isn't entirely rosy, though. Some tech companies overexpanded in the late 1990s, so they're reluctant to make new capital investments. And since commercial banks are working through enlarged portfolios of bad loans, they're not eager to encourage new borrowing. Consumer spending may keep the economy chugging, but more robust growth awaits a turnaround in capital spending.

Perhaps the best news for stock investors nowadays is that inflation is near 38-year lows -- and interest rates reflect those inflation trends. From here, rates may tick up, but they'll probably remain moderate by historical standards.

When inflation and interest rates are high, blue chips can trade at P/Es two to four points below the norm (for example, 12 instead of 16). By contrast, when inflation and interest rates are unusually low, average multiples of 18 or 20 can prove sustainable.

At this point, GDP growth is projected to recover well, even if not to the boom peaks of 1997-99. Earnings for large, high-quality stocks should similarly rebound strongly over the next few years. Until those earnings gains come through, P/Es will look high.

Currently, the multiple for the S&P 500 tops 30, based on depressed 2002 results. But if you figure P/Es on longer-term earnings trends, as the Leuthold Group does, then the market's current multiple appears quite moderate.

Whatever uncertainty specific companies may face in 2003, over the next five years the broad market figures to provide respectable gains from today's depressed levels. Moreover, stocks should outpace income investments such as bonds.

In theory, the greatest upside potential is in top-quality tech stocks, which have given back their excess gains of the late 1990s. Obviously, such stocks are volatile in the short run. But since I have a long time horizon, I have much of my own money in diversified indexes of large-cap growth stocks, such as the Technology SPDR, traded on the American Stock Exchange with the symbol XLK (XLK: Research, Estimates).

Whatever types of stocks you choose, this is a time to diversify as broadly as possible, which protects you against the risk of a business collapse or accounting fraud at any particular company. It also makes sense to balance your stock holdings with bonds.

Just remember that bonds have their own risks: Long-term interest rates are very low right now and could rise suddenly by as much as a full percentage point. With such a spike, bonds could lose more than stocks.

For the stock part of your portfolio, this is a great time for a major S&P 500 index fund, such as those offered by Fidelity and Vanguard. A more conservative choice would be an equity-income fund such as T. Rowe Price Equity Income.

For the bond part of your portfolio, you can lower your risk with intermediate-term Treasury or GNMA funds. American Century offers a good selection, as do most of the major fund families. Some analysts argue that corporate bonds or even junk bonds are preferable, since their higher yields offer a cushion in the event that rising interest rates create capital losses.

If you'd prefer to buy just one fund, consider Vanguard's hybrids. Wellington and Wellesley Income offer a very conservative mix of stocks and bonds. So does the Vanguard Balanced Index fund, which invests roughly 60 percent in stocks and 40 percent in bonds.

When the market looks as fragmented as it does today, there's no shame in hunkering down with a bet on the broad market. Given a rebound, a portfolio built around a cross section of stocks may well minimize current uncertainties and still outpace the 12 percent historical average earned by the S&P 500.