Opening thoughts
KAREN GIBBS: I'm Karen Gibbs.
GEOFF COLVIN: And I'm Geoff Colvin. Welcome to Wall $treet Week with FORTUNE.
In week three of the war, better news from Iraq meant better news on Wall Street. Right now you'd think nothing else matters to the markets - but of course much else will matter, and I'll talk with two veteran forecasters about the possibility of a boom after the shooting stops. And Karen will ask whether, in this jittery market, you should be picking individual stocks at all. Her guests hold decidedly differing views.
While this week's war news was good for most stocks, the war in general has been terrible for America's airlines, which could lose over $10 billion this year. Congress's efforts to help got stuck at the notion of subsidizing a failing industry that pays its top executives millions. Delta CEO Leo Mullin's compensation package was valued at $32 million last year. Yesterday he said he'd give up much of his pay this year. But that apparently failed to clear Congress's sympathy hurdle. Both houses last night passed bills that aid the airlines - and limit airline executives' pay.
The dramatic war news has made the latest corporate scandal easy to miss, but don't miss it. In just the past five days at HealthSouth, America's largest chain of rehabilitation hospitals and clinics, the board fired CEO Richard Scrushy and the auditors, the company defaulted on an important bond payment, and six employees pleaded guilty to criminal charges, including conspiracy to inflate profits by up to $2.5 billion.
This is WorldCom-scale fraud, as seamy a tale of greed as we've yet seen, and we'll keep an eye on it. The stock, once $30 a share, closed the week at 13 cents. And by the way, one of its most ardent boosters was an analyst at UBS Warburg, which happened to be HealthSouth's investment banker. Not until after the fraud allegations came out did he finally change his rating on the stock - from "buy" to "reduce."
Karen, a bit more buying than reducing in the markets this week -- what happened?
Market summary
GIBBS: Geoff, while Wall Street remains preoccupied with events over there, there were some big doings this week over here.
While the war effort appears to be going just fine, the economy stinks. The unemployment rate held steady at 5.8% in March, but the economy lost 108-thousand jobs…over one-third of those losses in travel related sectors. Not the kind of news on which to build a rally. But rally the markets did.
First, as we quickly approach tax day, the mother of all tax preparers, H&R Block said its offices handled fewer tax returns than they did at the same point last year, prompting a downgrade from Goldman Sachs.
Shares of Altria got smoked this week after its Philip Morris unit announced it cannot afford the $12 billion bond required to appeal a recent court ruling. Not good news for cash strapped states that have become addicted to all that cigarette money flowing into their coffers since the 1998 tobacco settlement and are still in desperate need of cash.
And retailers are suffering from a war effect of sorts. Borders Books said traffic and sales have slowed as the nation focuses on the ongoing war.
But in the typical "What, Me worry?" fashion, Wall Street charged ahead, with all major averages moving into the plus column this week.
The Dow added 100 points on the week. The Nasdaq better by 30. The S&P picking up 14.
Morningstar style boxes give the edge to small cap value.
Thanks to the airline industry's aid package, American Airlines parent AMR soared 130 percent, but don't go cashing in those frequent flier miles just yet.
Post-war economy discussion
COLVIN: What happens to our economy -- and our investments -- when the war ends? A sudden boom? More tough slogging? The answer depends on much more than how the war goes. While most of the public and the news media are transfixed by coverage from Iraq, Congress is about to enact a budget and tax cut package that could affect growth, jobs, and investments for years to come. The stakes are high.
 Here with insight into what's ahead is Kevin Hassett, a resident scholar at the American Enterprise Institute who has advised President Bush on taxes and the economy, and William Dudley, chief U.S. economist at Goldman Sachs - forecasting the economy is his job. Gentlemen, welcome.
Kevin, I gather that you think there is at least a fair chance of a real boom in the economy and the markets when this war ends, right?
KEVIN HASSETT: Yeah, that's right.
You know, we saw at the beginning of the war when it looked like it wasn't going to go as bad as maybe some people feared, that the markets really celebrated. I think that the question is, is the market right now a little bit afraid that Saddam still has something really bad that he can do to either our troops or maybe to Kuwaiti oil fields that could interfere with the development of markets worldwide? And I think that once we think that Saddam's finished -- you know, maybe we don't actually have him in our custody but we don't think he can fire missiles at Kuwait oil fields and so on -- that we should expect to see another market celebration, and it could be a significant one. And if it is significant, then that's good news for the economy.
COLVIN: So then the economy you think might follow as well, because it's certainly in the doldrums now.
HASSETT: Well, if you look at last year, it started in the beginning of the year to look like a typical recovery, which was surprising, I think, to many of us. But then near the end of the year, we really slowed down sharply, and I think we slowed down, because as (Federal Reserve) Chairman (Alan) Greenspan said, the geopolitical risk started to make people hold off on their big capital spending plans and the price of oil skyrocketed. So I think that if the geopolitical risk is out of the equation and the price of oil is back in the sort of $25 a barrel range, then there's no reason why we couldn't end up above where we were headed last year, which is 3 percent growth, and that's a pretty darn good year.
COLVIN: It's pretty good. Bill, you're not so optimistic, right?
WILLIAM DUDLEY: Well, I think that the economy is suffering from more than just geopolitical risk. I think the stock market bubble has burst, and that's causing balance sheet adjustments by business, households, and state and local governments, who are finding that they're faced with very large operating budget deficit shortfalls. That adjustment process is underway, which is good, but we think it's not completed yet.
Also, if you think about monetary and fiscal policy, we got a lot of support to the economy last year from both, less support this year, because the tax cut package hasn't been passed yet. And on the monetary policy side, most of the effects have already been felt. Housing is up, autos are up, mortgage refinancing activity is up, so you're not going to get as much benefit from that going forward.
COLVIN: How much stimulative effect do we get from the big drop in the price of oil that we've had these past few weeks?
DUDLEY: I think you definitely get some effect. We use as sort of a rule of thumb, for every $10 a drop in a barrel per oil, it might add about a half percent to GDP growth. The drop we've had is less than that, so it's definitely a positive, but I don't think it's strong enough to generate a very strong, robust economy quite yet.
COLVIN: The tax package that you mentioned is before Congress now. The House and Senate have passed differing versions. Most people seem to think they'll split the difference. Some people have said this tax package is of historic importance, comparable to Reagan's tax cuts of 20 years ago. I want to ask both of you, do you think it should be enacted?
DUDLEY: Well, I think we definitely need near term fiscal stimulus, because that actually helps facilitate the balance sheet adjustment. Households want to save more because the stock market hasn't been doing very well over the last few years. If you give them tax cuts, they can save more without cutting back on their spending.
The real debate, I think, between the Democrats and the Republicans, (is) "Is this the right tax plan to stimulate the economy in the near term?" You know, the dividend exclusion is quite controversial because it costs quite a bit of money and the effects are felt over the longer term rather than right in 2003 and 2004 when the economy really needs the help.
COLVIN: Yeah, good point. Kevin, what do you think? Should it be enacted?
HASSETT: Yes, I think definitely it should be enacted, I think in particular, the dividend part of the proposal. You know it's true that a dividend tax reduction has benefits that are spread out over the long term, but if markets are efficient, it's good news for the market right now.
 You know, the price of a firm ought to be related to how much that firm can put in your pocket over time, and that's a price response that we could see immediately if the dividend tax proposal is passed. And so I would expect that if the dividend proposal does pass -- and I think something like the President's bill will pass -- then we'll see a celebration in the market. And if that's timed to coincide with the end of the war in Iraq, it could really be quite a positive development.
COLVIN: But now you've said a couple of times that if we get a celebration in the market, it's good for the economy, but isn't it supposed to work the opposite way? Right? If the economy is looking good, then the market will respond.
HASSETT: Yeah, that's right. I mean, and basically they're simultaneously determined, and I think right now if we look at the fundamentals of the economy, that the negative effects of the decline in the stock market from a couple of years ago have abated, that the capital overhang measures seem to be saying that there's not as big an overhang anymore, and so that the drags can reverse themselves and the economy could really take off. And so therefore the stock market thing could sort of be the sign to start.
COLVIN: And that was some economist speak, but what it means is that businesses may have to start capital spending, which really could help the economy move.
HASSETT: Right.
DUDLEY: The real problem I think is our businesses are going to start spending on capital investment before they see the increases in demand. You have a little bit of a chicken-egg problem. Do you invest before you see the demand, or do you wait for the demand? If you wait for the demand, then it's hard for the economy to really cycle up.
Another problem the economy has is the economy has been really depending on mortgage refinancing activity, people borrowing money from their house. That's an automatic break on the economy once the economy starts to strengthen, because one consequence of a stronger economy will be higher interest rates, and you'll turn off that mortgage refinancing engine.
COLVIN: How much of a window do we have left for that particular activity? Kevin, what do you think?
HASSETT: I think it's very important for our listeners to check, because the odds are it's still a good time to refinance for people who haven't refinanced in the last six months.
COLVIN: Bill, what do you think?
 DUDLEY: I think the mortgage refinancing is still helping, but I think it's going to be less powerful going forward, for the fact that, you know, once you refinance once, there's less money to pull out of your home the second time and the third time.
And, two, I think home prices are starting to go up more slowly around the country.
COLVIN: Yeah, we have seen that. Kevin, I want to focus for just one more minute on the dividend tax exclusion, because that does seem to be the hot button in the President's tax proposal. Now I know you've spoken to the White House and the President about this. There's going to be some horse trading between Congress and the White House before this becomes law. How committed do you think the President is to the dividend tax exclusion?
HASSETT: I think that the President has said on the record, and he certainly to a group of economist that met with him, including me, in the White House a while ago, that he's a hundred percent committed to having the whole thing or nothing. And, you know, the fact is that Washington being Washington, you have to sort of read between the lines, and is that really what he means? Is he not going to horse trade when he can have something but not the whole thing? And, you know, my guess is, from talking to all the principals around town, that they're looking at some kind of compromise that might involve cutting it in half or so. And so if we had to guess what's going to happen, I think that might be a good forecast right now.
COLVIN: Good to know. Bill, things don't always go right. We've been talking so far mostly about the upbeat scenario. But you've looked into other scenarios. What could go wrong and what could we worry about?
DUDLEY: Well, a couple of things that could go wrong is one, we win the war with Iraq, but maybe the peace is difficult, and two, we win the war with Iraq, but that doesn't eliminate the geopolitical risk. We have geopolitical risk with respect to North Korea, maybe Iran. There's some talk about Syria. So the geopolitical risk may stay with us, even with a victory over Iraq very shortly.
COLVIN: A final question, you both at earlier points in your careers were economists with the Federal Reserve. Now based on that experience, plus everything else you know, do you think the Fed will cut rates on May the 6th?
DUDLEY: I think there's a very good chance of it. I think that there's a lot of speculation about the Fed moving in or meeting before May 6th. I don't think they're going to move that quickly, because they want to be patient. They think that it is mostly geopolitical risk restraining the economy. But if the economic news stays as bad as it's been, it's going to be hard for them to resist when they sit down on May 6th.
COLVIN: Kevin, what do you think?
HASSETT: I think that Chairman Greenspan has conveyed to the market that he's concerned that the celebration over the end of the war with Iraq could get us into something that gets carried away, growth gets too high, maybe inflation starts to take off. I think that's one reason why they sort of held back right now and they've been holding back despite the fact that, as Bill said, the data have just been awful. And so I think that it's quite likely that if the war with Iraq has resolved itself and we don't see the amazing celebration that we began our segment talking about, that they will reduce rates again.
COLVIN: Kevin, Bill, thanks so much for your views.
FORTUNE 500
COLVIN: Our colleagues at FORTUNE this week released the brand new FORTUNE 500 ranking, and as always it contained fascinating insights for investors.
Who's biggest? Wal-Mart by a mile, followed by General Motors and ExxonMobil, the former titleholders, then Ford and General Electric.
One of the most interesting findings is that not all 500s are the same. The FORTUNE 500 collectively has been a better investment than the S&P 500 over the past year -- and the past ten years.
The very best investments in the FORTUNE 500 last year were Crown Holdings, a maker of cans and packaging, Tenneco Automotive, Providian Financial, a credit card issuer, Pacificare Health Systems, and, believe it or not, a dot-com -- Amazon.com.
Several famous companies finally grew big enough to join the 500, among them Ace Hardware, Starbucks, and at Number 500, Neiman Marcus. Another newcomer is less well known -- but that may change soon.
The cars on America's roads are getting older. And that's good news for Advance Auto Parts. The Virginia-based retailer has been doing more than selling car parts in recent years. It's been doing some shopping of its own… buying up a handful of competitors and multiplying its stores and sales. Advance is now the nation's second-largest auto parts retailer, behind Auto Zone.
Its new-found status among the Fortune 500 puts it a long way from its 1932 roots as a tiny local chain.
LAWRENCE CASTELLANI, CEO OF ADVANCE: We're very proud of it. Our people are very proud of it. When our people first heard we were in the FORTUNE 500 and we were listed at 466 on the FORTUNE 500, they were very excited, and the first thing they were asking is how do we get to be 400 on the list.
COLVIN: Advance Auto Parts went public in November 2001, at a time when Wall Street believed auto part retailing was a good recession play. Consumers would keep their old cars longer, Street logic went… and do their own repairs instead of paying a mechanic.
Advance Auto Parts stock is up nearly 19 percent since its IPO. The S&P 500 is down 22 percent in the same period.
CASTELLANI: Simply put, our customer base just doesn't consider a dead battery a discretionary purchase.
COLVIN: In a recent research note, Salomon Smith Barney says Advance is still "an excellent way to play the retail market without significant exposure to volatile consumer spending."
In fact, some consumer trends are expected to help sales.
 CASTELLANI: For the first time in history in the year 2002, last year more vehicles sold in the U.S. were made up of the vehicle population of light pick up trucks and suv's. And that's very important to us because the parts on those vehicles, the replacement parts, go for an average ticket price that's considerably greater than in a passenger vehicle.
COLVIN: Equity analysts say Advance Auto Parts should have no trouble meeting its 25 percent earnings growth targets this year. In fact, they think the stock is undervalued.
Still, there are risks. Advance took on a hefty load of debt to finance its growth… and some of its acquisitions could take longer to integrate into the chain than expected.
But neither managing debt nor converting stores is new to the company. Despite the same challenges last year, it managed to rank in the top 20 on another FORTUNE list: fastest growth in profits.
Investor spotlight
GIBBS: "The S&P 500" -- even a casual observer of the markets hears and reads those words dozens of times a week, the benchmark by which most investments are measured. But now fund giant Vanguard, the company that practically invented index funds, is changing the rules, and the benchmarks.
Gus Sauter not only runs all the index funds -- he's also about to become the key decision maker on how Vanguard invests $400 billion between stocks, bonds and index funds.
Marty Whitman, the legendary chairman of Third Avenue Value fund, says forget index funds. If you buy cheap, safe stocks, investors will make money. He especially likes taking big chances on distressed companies that others have soured on. Marty joins us from New York.
Gentlemen, welcome.
Well, Gus, let me start with you. Why the change in the benchmark?
 GUS SAUTER: Well, over the last 10 years, within my group we've identified characteristics that we think constitute the ideal characteristics for an index. About a year ago, MSCI, Morgan Stanley Capital International, came out with a new index, or announced a new index that they would be coming out with. We looked at the construction methodology and determined that in fact they met most of the criteria that we have identified as being ideal characteristics for an index.
When they finally started producing some data this year, we analyzed the data, and we were very impressed with the style integrity. In other words, the indexes really measure the segments of the market they're designed to measure. The large-cap index is a very good measurement of what's happening in large-cap stocks. The small-cap value index, for instance, turns out to be a very good measurement standard for what's going on in the small-cap value market.
And the other factor is that they tend to have lower turnover than many of the commercially available indexes.
GIBBS: All of that sounds very good, but what does it mean for the individual investor?
SAUTER: Well, it means that if they're investing in, let's say a large-cap growth stock, they're going to get a return that really reflects what's going on in the large-cap growth portion of the market. The worst thing you'd hate to happen is to invest in a segment of the market and have it be the segment that does outperform, but not really being reflected in your index fund. So they'll know that they're going to get the performance of the segment of the market that they select.
GIBBS: Marty, what do you think about indexes?
MARTY WHITMAN: Well, indexes bottom on a theory that the market knows more than you as an investor can possibly know. For us, that's arrogant nonsense. We would never invest in a security unless we knew a lot more than the market did, in terms of what's important.
I think indexes grew out of modern capital theory, which really is very, very sloppy scholarship. Basically the theory behind an efficient market is that an investor can't outperform a risk-adjusted benchmark in terms of total return consistently. That's what the theory said, and you ought to know that "consistently" is a dirty word. It really means all the time. I would agree with that. I would think index funds are superior to people who think they can beat the market on day-to-day trading. But that is really such a small minority of all investing, and basically investing, if you want to do well, has to be grounded in fundamentals where you know more than the market about what's important, and things that are important are a lot more than predicting next quarter's earnings.
GIBBS: Well, Gus, let's talk about that, because a lot of people pick investment styles based on where they think the economy's going, and you say that you shouldn't look at the economic outlook or forecast in determining investment styles. Isn't that a contradiction?
SAUTER: Well, not really. We think investors really should establish an asset allocation or an investment program based on their own personal needs, regardless of what is going on in the economy. So someone investing today should come up with the same investment program that they might have come up with three years ago, regardless of the fact that the market is way off. We think that a rational investor should allocate some of their money to stocks, some to bonds, and some to money markets, depending on their own personal situation, and not try to guess which type of investment will outperform or which segment of the market, if you're talking about just stocks, whether it's large cap or small cap.
GIBBS: So you're going to be taking over like $400 billion of the assets, and what are you going to tell those investors? Index, actively-managed funds, or bonds?
SAUTER: I think that there's a place for both index funds and actively-managed funds.
Index funds are great core holdings. They tend to outperform the majority of active managers. So for investors that don't want to take additional risk, manager risk, if you will, an index fund could represent a portion of their portfolio or all of it.
On the other hand, investors that want to take a risk on a manager that's trying to outperform the index, then they can invest maybe some in indexing, some in active managers. In so far as stocks versus bonds, as an example, bonds can also be indexed and purchased that way. But the allocation between stocks and bonds should be a personal decision. For some people, it's 20 percent stocks, 80 percent bonds. For other people, it's the other way around, 80/20.
GIBBS: Is it too late to jump on the bond bandwagon? You're looking at very low interest rates, and our previous panel said we might even see the Fed go lower in rates, but there's not so much more that they can move.
SAUTER: Well, the large part of the upside is behind us, but that doesn't necessarily mean that bonds will back up. I think that investors still should have some bonds, because they add stability to a portfolio.
GIBBS: Marty, you've made millions in investing in distressed stocks and bonds, and particularly you're one of the largest creditors of Kmart. What's going on there?
WHITMAN: Well, one, we don't invest in distressed stocks. Anytime a company's in distress, our investments are as a creditor.
GIBBS: Well, talk about Kmart.
 WHITMAN: Kmart, all right. We're in the group that's going to take control of Kmart in an equity reorganization. And the funds we're putting in gives reorganization to value to Kmart of approximately $1 billion. For that, we get a base revenue, a base annual revenue of approximately $25 billion or a little better, and we also get an awful lot of cheap, attractive real estate.
If the thing works, it works extremely well. There are, I think there are three factors that will determine whether or not this Kmart investment is a home run. I hope it would be. And those three factors are management, management, management. And I think we have the right, well, I have confidence that ...
GIBBS: Julian Day, the CEO.
WHITMAN: In Julian Day, yeah, that we have the right CEO and we'll see how the thing plays out.
GIBBS: You're also looking at some utilities and real estate yourself, St. Joe Industries as well as PG&E. Quickly, why?
WHITMAN: Well, I mean I have a long background in utilities. I don't know a regulated utility that's ever not made its bondholders hold. Since I started in 1979 when I was financial advisor to the President's Commission on the accident at Three Mile Island, then Pacific Gas & Electric, we bought the first mortgages at a 25.5 percent yield to maturity, and I figured they'd never miss a payment. We bought Aquila...
GIBBS: Marty, I've got to wrap it up here. Thanks for talking with us. And, Gus, thank you for joining us, too.
SAUTER: Thank you.
COLVIN: We love to hear from you… Please write us at Wall $treet Week with FORTUNE, Owings Mills, Maryland, 21117, or e-mail us at wsw@pbs.org.
Next week, we'll take an in-depth look at the food industry… You may even find out how to fatten your wallet-while slimming your waist.
GIBBS: And we'll also hear from one of the nation's top strategists, Tom McManus from Banc of America. He's ready to buy.
Coming up on many of these PBS stations: NOW with Bill Moyers.
Good night.
COLVIN: We'll see you next week.
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