(FORTUNE Magazine) – IS IT TIME to turn away from stocks? No, not yet, though your nervousness is understandable. Approaching 4000, the Dow Jones industrial average seems dangerously high. After 40 months without a 5% to 10% correction, vs. an average bullish run of 27 months, the market is indeed long in the tooth. But the power of investor cash and strong earnings cannot be ignored. Despite this rising market's advanced age, its total return to investors is still subpar, just 63% so far, vs. an average bull-market increase of 80%, notes Jeffrey Applegate, chief investment strategist at CS First Boston. More money can be made in 1994. The key to making it will be following new guidelines for picking stocks. In this stage of the game, when interest rates are inching up and the expansion is in full swing, the kinds of stocks that will perform best are different from those that led this bull market. The road to riches requires looking at the parts of the stock market that are not aging and worn out but merely primed to take off as the economy's engines roar on. Rising interest rates means a new chapter for the market. For years declining rates boosted stocks, making them more attractive than fixed-income investments. But in February the Federal Reserve reversed gears, raising the federal funds rate, which reflects the interest levied on overnight interbank loans, from 3% to 3.25%. The Fed billed the move as a preemptive strike to ward off any hint of rising inflation, evidenced most recently by increasing commodity prices. Investors initially took the news badly, lopping 96 points off the Dow in one day. But those who sold may have acted too hastily. More critical to the bull market's longevity than any single uptick is how fast and far interest rates rise. Treasury bills will have to pay 3.7% or more, says Elaine Garzarelli, the Lehman Brothers quantitative analyst, before the stock market loses its appeal. Her conclusions are based on a look at past patterns of market performance, which show that T-bills need to pay at least one percentage point more than the average dividend yield on stocks before the latter suffer. Three-month T-bills recently paid 3.3%, and the dividend yield on stocks was 2.7%. If the Fed succeeds in keeping a check on inflation, the bull will have more room to run. Roger Ibbotson, president of Ibbotson Associates, a consulting firm in Chicago, and money manager Gary Brinson of Brinson Partners, also in Chicago, have studied the effects of inflation on stocks from 1946 through 1990. When inflation remains steady in a 1% to 4% band, as it has so far since 1990, stocks return an average of 10.7% annually. But when inflation is rising, regardless of its level, the picture changes. Annual returns are much lower -- just 1.8% -- in years when year-over-year acceleration has been as moderate as 5% or even less. Whatever happens with inflation, rising short-term rates will eventually make cash more comfortable to hold. In addition, long-term rates are getting chunkier; the 30-year Treasury recently sported a 6.5% coupon, up from a low of 5.8% last October. These fatter yields will lower the attractiveness of stocks, represented by the P/E multiple on the market. Stocks in Standard & Poor's 500-stock index recently traded at 23 times trailing earnings. The average historical P/E multiple for stocks is 14. If earnings don't come through fast enough, prices will have to fall to make stocks look more reasonable. But while rising interest rates may eventually slay the bull, that's unlikely to happen soon. One reason is that near-term advances in earnings could pull down those lofty P/Es. Applegate of CS First Boston thinks earnings will continue to surge. He figures S&P 500 operating earnings per share will come in at $27 for 1993 and $31 this year, representing successive year-over- year increases of 15%.

When compared with expected 1994 earnings the market looks more reasonable, trading at a P/E multiple of 15. Companies have been reporting strong gains through cost cutting and modest price increases in sectors like autos. An economic turnaround in Europe would spell more good news, as 20% of earnings for the S&P 500 come from there.

WHAT ELSE will keep stocks rolling? Billions of dollars have been flowing into equity mutual funds each month. Estimates from the mutual fund data source AMG Data Services in Arcata, California, show the pace retreating in February, but the trend isn't firm. Says Neal Litvack, director of mutual fund marketing for Fidelity Investments: ''We see absolutely no slowdown.'' Strong inflows of cash do more than boost funds' buying power; they also keep managers from having to sell stocks to meet redemptions, a move that could precipitate or accelerate a market fall. The best way to make money in the stock market now is to choose stocks by playing the business cycle. In general, different kinds of stocks do well at different stages of the cycle. In recession, just before the economy bottoms out, financial stocks fly in anticipation of interest-rate cuts. In the early stages of recovery, when interest rates are lowest, the stocks of automakers and homebuilders excel as consumers respond to low rates on loans. Industry beefs up next, benefiting makers of capital goods. Manufacturers then want more raw materials, and commodity prices heat up, along with the stocks of commodity producers. Finally, as growth slows and the cycle turns, investors rush to companies insulated from the economy. A useful way to envision this change of command is as a series of rolling hills, with peaks leading to valleys and again to peaks (see chart). The pattern is classic, and every cycle is full of exceptions, but it nonetheless holds up today. Look at how various stock groups have performed in this bull market, which began in October of 1990. Financial stocks, the first to advance, have led all comers, gaining 131% through last September. But they've since lost 3%, and as a group they face a fierce headwind as interest rates rise. Conversely, stocks that aren't highly sensitive to the economy, like those of food and beverage makers, have so far been in the shadows. These consumer staples stocks have underperformed the S&P 500, rising 42% vs. a 58% hike in the index. The place for your money today is in economically sensitive stocks. The economy roared to life in the fourth quarter of 1993, with gross domestic product increasing at a 5.8% year-over-year rate, and while no one expects that pace to continue, most economists look for a long stretch of solid growth. Says Peter Canelo, chief investment strategist for NatWest Securities: ''I'd confine my investments to earnings-driven cyclical companies. If we do get inflation, they will do well anyway.''

BUYING STOCKS that perform best in an economic upswing will involve a few decisions: Do you want a stock that has already performed well, or do you want to go with stocks just starting to turn? Joseph McAlinden, chief investment strategist at Dillon Read, offers this reading of the economic curve: ''In my view, consumer cyclicals like autos are 75% of the way through their bull market phase. Capital goods makers like Caterpillar have had huge moves, so maybe they are halfway through. But industrial materials -- commodities -- are still in the first 20% of their run. The play here is just getting under way.'' Basic materials include steel, paper, chemicals, and metals like aluminum, copper, or gold. Prices for commodities in the Commodity Research Bureau industrials index bottomed in September and have since risen 16%. Steel companies, sheltered by tariffs from a rash of imports, have been leaders in raising prices. Spot prices have increased at least 60% since the summer of 1992. Many stocks in this industry have done well, including USX-U.S. Steel, which has about doubled from a nadir of $22 per share in 1992. But earnings are only beginning to come through, a sign that more gains are likely. Lehman Brothers analyst Richard Aldrich, who rates the stock a buy, believes earnings at USX-U.S. Steel should increase from a few cents per share last year to $2.80 in 1994 and $6.30 in 1995. Paper companies that own timberland, such as Weyerhaeuser and Georgia- Pacific, have been riding price increases since the call to protect the spotted owl and rising homebuilding demand made timber more valuable. Other forest products prices are following. Prices for linerboard, recently $320 a ton, increased $25 in the fourth quarter of last year. CS First Boston analyst William Wigder expects Georgia-Pacific to earn $1.75 a share this year, up from 26 cents in 1993. Weyerhaeuser, an early leader that earned $2.28 a share last year, should earn $3. It was recently at $48, and Wigder is looking for $57 within a year. The biggest gains to come may be in metals, the top industry pick for Canelo of NatWest. Aluminum, copper, and nickel have been in oversupply, with Russia unloading huge quantities, and worldwide demand has been weak. But production has been cut back, and inventory levels should decrease. Prices started ticking up last fall: Copper, for example, now sells for 84 cents a pound, up from a seven-year low of 72 cents last October. Demand in North America and East Asia was finally strong enough to shrug off weakness in Europe and Japan, which buy 40% of the world's copper. As those economies recover, demand should increase and prices should climb. Elaine Garzarelli at Lehman Brothers expects rising prices to produce stellar earnings gains for metals stocks in the S&P index. She thinks Asarco, Cyprus Amax Minerals, Inco, and Phelps Dodge will outperform the market this year on earnings gains of 690% from a very depressed base. Inco, a leading nickel producer whose shares sold recently for $26, is recommended also by Lehman analyst Aldrich. The other stocks are all top picks of Canelo, whose favorite of the bunch is Phelps Dodge. The leading copper company is getting strong earnings gains on the side from Phelps Dodge Industries, which manufactures products like carbon black for tire treads, and electrical cables. He expects earnings per share to rise from $2.66 last year to $5 this year and $6.50 in 1995. At $56 a share, the stock sells at a low 11 times expected 1994 earnings. Cyprus Amax Minerals, created from the merger of Cyprus Minerals and Amax last November, is a diversified company that mines copper and coal and owns 40% of Amax Gold. Asarco is another copper play. Cyprus shares recently fetched $30; Asarco sold for $26. Back down the curve, capital goods stocks remain buys as American companies , move from cost cutting and restructuring to expanding once again. Last year spending on fixed investments by business increased 12%, led by a 22% surge in spending for information technology. Morgan Stanley economist Stephen Roach is looking for another 12% gain this year. That would give business capital spending a 13% chunk of the GDP pie, surpassing a record set in 1985. Says Roach: ''Make no mistake about it, this capital spending boom is for real.'' Morgan Stanley analyst John Mackin recommends earthmover Caterpillar and Tenneco, which makes farm and construction machinery. Caterpillar's stock is reaching new highs and recently traded at $111 a share. Earnings for the fourth quarter surpassed analyst expectations, and momentum is building. Cat earned $3.41 per share last year, and Mackin is looking for $6 per share this year and $7.75 next. His 12-month target: $120. Tenneco, $58 a share, has the power to reattain its past highs in the low $70s over the course of this cycle, says Mackin. He's looking for earnings of $3.55 per share this year.

LOOK TOO at transportation -- a stronger economy means more goods to move in trucks and on the rails. Ardent cost-cutting propelled rail stocks in the S&P 500 up 21% last year, even without much in the way of revenue improvements, which are bound to come. Applegate of CS First Boston likes CSX, a $90 stock trading at 15 times estimated earnings for 1994. Federal Express offers a different transportation play, one that would benefit from a turnaround in Europe. The target price on the $77 stock is $90. And what of the auto stocks? You could lament that you've missed their big advance -- or buy them if you want to catch their final run. Near the end of 1991 shares of Chrysler sold for $10, Ford motor was at $23, and General Motors was $27. Today the stocks sell for $58, $64, and $60 respectively. What's left? Scott Merlis of Morgan Stanley thinks consumers still want cars, and doesn't expect earnings for the companies to peak until 1997. His 12-month price targets are $85, $85, and $90.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART CAPTION: A MARKET ON THE MOVE

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: MERRILL LYNCH CAPTION: USE HISTORY AS YOUR GUIDE Following historical patterns, financial stocks have had this upswing's longest run; they've recently lost ground. Consumer staples have yet to take off. Capital goods and basic industries are today's best bets.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: CS FIRST BOSTON CAPTION: ACTUAL PERFORMANCE IN THIS CYCLE Following historical patterns, financial stocks have had this upswing's longest run; they've recently lost ground. Consumer staples have yet to take off. Capital goods and basic industries are today's best bets.