How to survive in a volatile stock market.

Until the market slowed, a bang-up start to 1998 had investors eager for more. Our experts map out what to expect now.

FOR INVESTORS YOUNG AND old, experienced or green, it's headscratching time. And what's got us all puzzled comes to this: how can the market keep defying all the rules, and all the pundits and all the experts who say things can't go much higher?

Talk about a surge of almost mythic proportions. Look at the Standard & Poor's 500, an index widely used to measure the market's strength and plot its direction. From 1995 on, it has risen in excess of 20% annually. And this year, having already gained over 18% by the end of July, the S&P 500 seems destined to rocket beyond the ozone. That's normally the best of news, especially when you take into account that $1,000 invested on January 1, 1995, in a fund that tracks the S&P would now be worth $2,680, a gain of 168%.

So why the jitters? For one, experts have told us year after year that there's a point when the market must finally take a breather. The pundits still maintain that stocks are the financial place to be: an average yearly gain of over 10% surely makes the market a better wealth-builder than your savings account, and a tidal wave of 401(k) money and investments by private individuals should keep it that way. But, peep a bit closer and the reason to fret becomes clear: stocks have zoomed to highs at a time when company profits, one of the key elements used to gauge how expensive shares should be, are sputtering. At some point, logic tells us, the two are bound to slam into one another and the concussion will bowl over the bull market. In fact, a brief reminder that markets go down as well as up came just a few weeks after our experts met. Stocks took a tumble the first week of August, with the Dow settling some 9% below its high for the year, set in mid-July.

Our last investment roundtable convened July 9, just after the halfway mark this year, to take stock of what's in store for the market. Our experts included Dail St. Claire Simmons, a principal with Utendahl Capital Management L.P. in New York City, who put a finger on interest rates and the bond market in general. We also invited three stock market experts: Randall Eley, president and chief investment officer of the Edgar Lomax Co., headquartered in Baltimore, joined us to bring a no-nonsense evaluation of market levels and stock values to the table; William Roach, a principal with Globalt Group Inc. in Atlanta, helped shed light on global markets; and Dawna Edwards, vice president and managing director of equity investments with Alpha Capital Management Inc. in Detroit, came with a slew of statistics on corporate earnings.

No matter what camp you belong to-stocks or bonds, growth or income--the text that follows should help clarify what's likely to take place in the next six to 18 months. We also asked our experts to highlight a few picks that make for good additions to your portfolio.

THE FED WON'T RAISW INTEREST RATES... AT LEAST NOT YET

It's always best to start looking at the stock market from the outside when it comes to interest rates. You've probably heard that interest rates and stock prices sit on opposite ends of a seesaw. The minute the Federal Reserve--the government agency that monitors both ends of that precarious balance--raises rates, money comes pouring out of the stock market and into bonds. Bonds, after all, pay a set, regular yield that investors find to be relatively risk-free. Stocks, meanwhile, are prone to go up and down in value, offering potentially greater return to investors, but they're riskier sources of wealth.

What's the Fed up to now? At one point late in 1997, Fed Chairman Alan Greenspan seemed to tip his hand by intimating that in his opinion stock prices could be drifting far too high. Dail St. Claire Simmons, our fixed-income expert, says the Fed has indeed gotten a bit fidgety, but probably won't tinker with rates. Meanwhile, with the U.S. government running on a tight budget, and borrowing less money as a result, interest rates should continue to fall. But one panelist, Randall Eley, thinks inflation might soon perk up enough to get the Fed a little more than concerned.

DAIL ST. CLAIRE SIMMONS: We started the year with the 30-year Treasury--the bellwether of the bond market--at a yield of roughly 5.90%. Rates have come down to 5.60%. We're expecting them to fall as low as 5.25% by year-end. We continue to live with a vigilant Fed, however. It's attuned to keeping economic growth at a reasonable rate without prompting higher inflation. We believed, in fact, that the Fed was actually going to raise rates last year, before the Asian crisis slowed the economy down.

WILLIAM ROACH: They [the Fed] really can't afford to raise rates because it's not clear how long the Asian crisis will last and what effect it will have stateside. Tighter monetary policy in this kind of environment could damage the economy. I think they have to remain, at best, neutral at this stage.

ST. CLAIRE SIMMONS: Inflation, meanwhile, seems pretty tame. Even with employment numbers rising--that inflation might rev up a bit--prices haven't jumped much. The wage gains that might have pushed inflation have been offset by productivity advances, thanks to technology. And moderate inflation will probably keep the Fed on the sidelines. Further out, meaning 1999, the economy may slow to the point that the Fed might ease rates.

RANDALL ELEY: Over the short term, we should see the Federal Reserve and, for that matter, all other political authorities, take a hands-off approach to the markets because we're entering election season. There seems to be an understanding that no one, not even the Fed, will take any action that's deemed to be interference in the elections, so I can certainly see this market-friendly environment continuing until the first part of November. Afterward, the Fed will probably be more willing to act upon its concern over inflation. For one, wages are growing at a substantially more rapid rate than the overall consumer price index. Inflation has remained at a tame annual rate of less than 2% so far this year because commodity prices have been especially weak. Some, like oil, in particular, have actually declined significantly. But outside of commodity prices, inflation seems to be growing at a considerably more rapid rate than the numbers are telling us. On top of that, it's entirely possible that oil prices have hit or are close to a bottom, and I mean a very long-term bottom.

A combination of wage increases and commodity price increases could begin to turn the tide. I think at year-end we could find that the inflation numbers are not quite as good as they have been and that the Federal Reserve might begin to behave in just a bit more aggressive fashion.

BIG COMPANIES LEAD THE MARKET

By most measures, the first half of the year was extraordinary for the stock market. The S&P 500 was up almost 14% in the first quarter of 1998 alone. That compares to an average yearly gain of at least 9% since 1926. The reason: big safe names, the largest corporations around, attracted investors who thought overseas markets might be in peril.

ROACH: For the first quarter, the stock market, or equity market, as we call it, ignored the Asian contagion. It rose on a euphoria based in part on lower oil prices, lower commodity prices, that helped keep profits going, and full employment that aided consumer demand.

A lot of overseas money helped propel the stock market as well. A strong dollar prompted very significant buying by foreigners the first six months of the year because our economy is very stable relative to the rest of the world, and particularly Asia.

During the first six months of the year, investors have gravitated to large companies with track records of consistent earnings growth. Large-cap stocks--a.k.a, the big corporations--have seen their stocks rise and rise. Meanwhile, smaller- and mid-cap companies look like bargains. The P/E ratios of the companies that make up the S&P 500, in fact, have risen as high as 28 times earnings, which are record levels, historically. Nevertheless, we've seen what's called a flight to quality, where investors flock to big, high-quality companies.

DAWNA EDWARDS: Currently, the economic environment is very favorable for the market. Interest rates are low, wages haven't risen too much, consumer sentiment is up, people feel good about the economy and so they're out there spending. At the same time, cash keeps flowing into the equity or stock markets because of 401(k)s and individual investors' interest in mutual funds.

While the bull market has remained intact, high valuation levels and the uncertainties in Asia have caused investors to seek quality. Because of this, investors have focused on large-cap, blue-chip issues. People are looking to invest their money where they can feel comfortable, sleep at night and get good returns.

ELEY: I want to just put in a bit of a caution here. I think it's important for to know that the market's gains have been abnormally high. You generally expect to earn 9%-10% in the market a year. The United States is going through an extremely good period, but I, for one, do not expect those kinds of numbers to continue.

SMOOTH SAILING UNTIL NOVEMBER. AFTER THAT?

Our experts think the good times will probably roll until the elections. Eventually, however, the market will have to catch a breather; price-to-earnings multiples--the gauge of how cheap or expensive stocks are--are higher than they've been in two decades. Look for stock prices to cool for a while before they advance further.

ROACH: Currently the S&P is at very, very high levels, trading at an average price-to-earnings multiple of 27 or 28 times. A lot of us would like to see that come down to the low 20s or so. Still, there's money pouring into stocks. Over the next six to 12 months, I really think you don't have a lot of risk of the market correcting significantly. What we're going to see, though, is a very, very volatile market, as we have for the last year. That's short-term.

ELEY: I think that over the next three to five months, it's likely the market will stay at about this level or maybe rise a bit.

EDWARDS: We see the market moving sideways as well, with occasional sell-offs of 10% or so, like there was in April. So far, whenever share prices go down, there seems to be enough people eager to get back into the market to help stocks bounce right back.

WATCH OUT FOR FALLING EARNINGS

Are you used to double-digit earnings growth propelling the market to new highs? Well, our experts say things are slowing down.

ELEY: We're already seeing corporate earnings growth projections decline dramatically from the beginning of the year. That's less than half of the normal amount, or around 6%-7%. I think what we're seeing is a normal development and, after a strong run of rapid earnings growth like that of the last three years, I fully expect that somewhere over the next 18 months or so we're going to have a quarter in which there will be no earnings growth and perhaps a decline. That's when I think the equity markets will wake up, and whether we'll have a significant correction or something a bit more serious, I don't know yet.

EDWARDS: If one looks at the second quarter, the S&P 500's earnings were up 3.5% over last year, down from an 8.9% increase registered a year earlier. That's also less than the 10%-plus returns that we saw in 21 of the previous 25 quarters.

LOOK FOR FINANCIALS AND OIL TO DO WELL

The past few years, banks and diversified financial companies have done amazingly well. Look for that to continue, says William Roach. And with oil prices near a bottom, Randall Eley says big oil is about to have its day.

ROACH: The financial services group looks good. Low interest rates help, and an older population saving more and planning for things like retirement and their kids' education bodes well, too. Higher healthcare costs are also spurring the insurance industry. We think companies like Citicorp (NYSE: CII) and American Express (NYSE: AXP) are part of the new wave of financial companies that should benefit.

The aging of America also makes the health-care sector look good. Pharmaceutical, HMO and biotech companies should benefit going forward.

Technology remains intriguing, too. It's driving the world going forward, but at the same time, it's been a very volatile sector. In this sector, we like the high-quality names longer term, which would really be Cisco Systems (Nasdaq: CSCO), Lucent Technologies (NYSE: LUC), Xerox (NYSE: XRX) and Microsoft (NYSE: MSFT).

ELEY: We're placing our biggest bets on energy right now, for two reasons. First, commodities prices are already down sharply. We think that oil prices are reaching a bottom. Higher oil prices mean higher profits for oil companies. In addition, the big refining companies like Exxon (NYSE: XON), Mobil (NYSE: MOB) and Chevron (NYSE: CHV) have had to competitive at a time when a lot of other companies have been able to lighten up a bit. Exxon has been restructuring over the last three years and constantly lowering costs. Therefore, the moment oil prices tick up, these energy companies are actually going to see their earnings jump quite nicely.

We also like basic materials and capital goods, the companies that make the basic products on which everything else is built. You're talking about companies like Dow Chemical (NYSE: DOW), International Paper (NYSE: IP) and 3M (NYSE: MMM). These are companies that are profitable but have already taken something of a hit recently and are cheap.

ST. CLAIRE SIMMONS: I'm bullish on bonds. For one, they have a place in everyone's portfolio, especially if you subscribe to the old rule of thumb that you buy stocks for growth, while you buy bonds for safety, security, principal and stream of income. For instance, it's a good time to look at municipal bonds. Currently, their yield is 90% of Treasuries, which is outstanding. And factoring in their tax-free nature, they look like a good bet.

Finally, I think this is a great time to teach our children how to save and invest. One way for them to learn about the principles of investing is to get into one of the mutual funds that caters to kids (see "Investing as Child's Play," Moneywise, October 1998). Another smart move is with zero coupon bonds, which don't yield interest directly to you, but instead accrue value over time.

As of July 7, 1998, the Treasury zero coupon bond maturing on March 15, 2018, requires a $310 investment, a gift you can give a child. In 2018, that same investment will be worth $1 000.

Dail St. Claire Simmons

Dali St. Claire Simmons, a principal at Utendahl Capital Management L.P., 212-797-2688 has a message for you: even as the market roars on, don't forget bonds. Bonds provide a great way to preserve wealth, albeit with some risk just like equities, while contributing a decent return to a portfolio. And with share prices skyrocketing, it's a good idea to review how your portfolio is divided between stocks and bonds. If you're a conservative investor who looks to have 50% of your money in bonds and 70% in stocks, an increase in the market is likely to throw that balance off. To keep things from getting too skewed, St. Claire Simmons recommends that you look over your portfolio twice a year, and move money from stocks to bonds to help lock in the profits you might have made from this bullish market.

St. Claire Simmons' take on the fixed income or bond market is pretty clear cut. Over the long haul, interest rates are probably headed downward. Applied to your portfolio, that means bonds with longer maturities of five to seven years or more look like a good bet. She recommends looking at your needs and structuring a laddered bond portfolio to meet them. For a child's college education, a portfolio might include four U.S. Treasury bonds slated to mature in succession as your child turns from 18 to 21, annually. That way, you'll be able to cash in on your investment and protect your principal with safe U.S. Treasuries when particular financial obligations arise.

Randall Eley

It's been a busy 12 months for Randall Bey, president and chief investment officer of the Edgar Lomax Co. He started the Edgar Lomax Value Fund (800-265-6438, www.edgarlomax.cihost.com), and signed on to manage another fund for Liberty Mutual Bank and Trust in New Orleans. Agencies that rank institutional money managers have placed Eley's company in the top percentile nationwide, in part because his average annual return is 22.6% over the last seven years, compared to 21.8% for the S&P 500.

A stickler for value stocks, Eley's come up with three interesting picks. The first is automotive giant General Motors (NYSE: GM). The company, which was selling at a price-to-earnings multiple of 8 as of press time, is a bargain. Meanwhile, GM sells at a price-to-book ratio of 2.8, and its dividend yield is almost 3%. Put together those two factors, Bey says, and investors get a solid ;55 cents in assets for every dollar they put into GM stock, which he feels should return about 15% yearly over the next five years.

Health insurer Cigna (NYSE: CI) not only sells at a P/E of 15, but at a miniscule price-to-book ratio of 2.1. Bey says that brings investors almost 50 cents in assets for every dollar invested. Couple that with Cigna's 1.6% dividend yield, and investors can look to an 11% yearly return even if earnings don't grow.

Finally, Bey likes International Paper (NYSE: IP) as a restructuring play. The company has struggled through a down period; it currently sells at a price-to-book ratio of a mere 1.5. Roughly translated, investors get 66 cents of assets for every dollar they put in. On top of that, it pays a 2.3% dividend and could well generate a return of 18% annually over the next four years, he says.

Dawna Edwards

Dawna Edwards isn't your typical "what-have-you-done-for-me lately" growth manager, the kind who's looking for companies that have recently logged a sizable spurt in profits.

Instead, she's after consistency. For Edwards, a principal with the Detroit-based institutional money management firm Alpha Capital Management Inc., 800-968-1870 that means corporations that have shown they can grow earnings steadily and dependably for at least five years.

One company that fits Edwards' bill is Newell (NYSE: NWL), which makes houseware products, such as Pyrex cookware; office products, including Stuart Hall school supplies and Rolodexes; and hardware and home furnishing products, like Kirsch window treatments. Edwards says the company has posted a very reliable 14% earnings growth rate on average for the past five years.

Edwards is also keen on retailer Home Depot (NYSE: HD), the nation's largest home improvement chain. With interest rates low and employment high, Edwards says, many folks are looking to put their money where their home is. Although shares trade at a price-to-earnings ratio of 43, Edwards says the stock has earned something of a premium if only because it has averaged growth of 23% annually over the last five years.

Edwards' last pick is Automatic Data Processing (NYSE: ADD), a provider of data processing and computing services, including payroll processing. One-third of all employers use a service bureau to outsource the payroll function, and this number is expected to increase due to year 2000 compliance issues. The company should benefit from this growth. Another plus: it has seen 36 straight years of double-digit earnings growth, Edwards says. While there's no guarantee that this will continue, the consistency of earnings growth and the quality of the balance sheet make the company an attractive holding.

William Roach Jr.

It's years like t998 when William Roach's take on international investing pays off. Globalt Group Inc., the Atlanta money management firm where Roach serves as a partner, taps domestic companies, provided they earn a major portion of their revenues from business overseas. That's helped Roach's institutional and mutual fund portfolio (877-289-4769, www.globait.com) fatten from a run-up in U.S. stock prices, while' sheltering it from the storm caused by Asia's problems. Longer term, the strategy has returned Globalt, which manages $1.5 billion in assets, a 22.7% yield annually for the last seven and one-half years, compared to 20.9% for the S&P 500.

Roach's first pick, financial services giant Morgan Stanley Dean Witter (NYSE: MWD), derives 28% of its revenues abroad. With demand for asset management services on the rise, Roach figures Morgan is good for a 16% average annual earnings growth. The stock currently trades at a price-to-earnings multiple of 19.

Roach likes Monsanto (NYSE: MTC), which transformed itself from a chemical company to a firm that spans agricultural chemicals, food ingredients and pharmaceuticals. Also, a recent merger with American Home Products will boost research and development. Roach says Monsanto, which bags 42% of its revenues overseas, should grow earnings at an 18% annual rate.

The scarcity of water should prove a boon to Roach's third pick, U.S. Filter (NYSE: USF), which trades at a price-to-earnings multiple of 19, and is slated to grow earnings 25% yearly. As a leading producer of water-treatment and recycling equipment, USF has tapped into industrial, commercial and municipal markets, and currently derives 37% of its revenues from overseas.