For our May 14, 2004 broadcast, FPA Crescent Fund portfolio manager Steven Romick sat down with Wall $treet Week with FORTUNE's Karen Gibbs and Michael Farr to talk about the uncertain environment surrounding the market these days. Here are portions of their conversation that didn't make it on the air:

MICHAEL FARR: When you look at the numbers, S&P 500 earnings are up about, something over 18 percent in the past 12 months. The market itself, the S&P 500 is up 16 percent. So the earnings have actually gone up more than the market returns. Therefore the price-to-earnings multiple has actually contracted for the S&P 500 over the past 12 months. So the market, by certain measures, is less expensive right now than it was a year ago, and investors don't like it.

Now, Steve's record is outstanding, so this is not a guy to bet against. But if you're looking -- I'm talking about a broad market right now instead of individual stocks -- even within our larger-cap style, we're still finding good values to invest in.

KAREN GIBBS: What do you think about Michael's argument that the market, when you take it in its totality, is actually undervalued?

STEVE ROMICK: I don't know that the market is overvalued, but I wouldn't go so far as to say that it is undervalued.

I think the stock market over the next five to 10 years should show returns someplace in the 4 to 8 percent range. It's a wide range I realize, but certainly it should be less than historic returns. Historically the stock market's returned 11 percent and change over the last 75 years, but of that, almost 4.5 percent of it was dividends. Dividends today are only 2 percent, and that combined with pension issues, options not being expensed across the board, as well as the fact that companies will not be growing, in our opinion, as fast over the next five to 10 years as they did over the last 75 years, I think, points to lower market rates of return.

For the stock P/Es to be less, as Michael said -- they are (less), because we've come out of a recession and we have the benefit of those higher earnings, so P/Es are less than they were a year ago because the market hasn't kept up. But that means too, if you think about it, at the beginning of that point in time a year and a half ago, was the market cheap then? And I'm not saying it's expensive. It's just not cheap enough for us to really put a lot of capital to work.

GIBBS: And you're very disciplined in looking for these discounted stocks that offer value.

ROMICK: Absolutely.

FARR: I think, though, as you look at a market and call it undervalued, I think it's undervalued perhaps prospectively.

If you look at a lot of the measures, you know, if we're at 18 times earnings right now on the S&P 500, historically there's nothing undervalued about that. In a low inflationary period or a low interest rate period, it's a reasonable multiple. If those rates start to rise, and this is a concern for investors, it's not so reasonable. As the economy's expanding with earnings that are expanding, free cash flow for the S&P 500 companies right now is enormous, and at any time when we've seen it pretty much near these levels, we've seen capital expenditures increase over 50 percent in the following three years.

So there's growth out there, but again, I would caution most investors not to buy the broad market and just go to sleep. I think individual stocks, the way that Steve does it, the way that I do it, is really the more prudent course.

There's something else that I think is fascinating here. He has a very good track record at what he does. Our track record's good. You listen to shows like this and listen to the experts and say, "Well, gee, that guy really makes sense, or, "She makes sense," or "He has very logical argument, I think he's probably right." We're looking at different sides of this issue, and our clients have enjoyed success over the long term, and that's really because he's going to stick with his discipline, I'm going to stick with mine, and you as an individual investor, stick with your discipline. If you don't do anything else, find your rules and stick with them.

ROMICK: I agree with that. There's no question that people get into trouble when they start changing and start shifting in the middle. And what I find is a definition of risk to me is losing money, but for most people it's volatility, because volatility is what scares people into the market and scares them out of the market. So the average investor gets whipsawed by that.

GIBBS: Energy affects just about everything, and we saw in this week's Producer Price Index that it's starting to hurt producers. It's also raising the fear that we're going to see, Michael, the Fed raise rates sooner rather than later. What are you hearing?

FARR: Well, yes, more economists are now beginning to think that the Fed will act at their June meeting. I don't think that anyone should fear that. I think we should embrace that. I think the Fed ought to show us that they're going to be decisive and they're going to do something now. They've told us they're going to do something. I think there's a great fear that this economic expansion might get away from them.

So, step up, Federal Reserve. Give us a quarter of a point. It isn't going to make any difference, but it will give Wall Street and investors I think some assurance that you are going to take action, you are going to intervene, and you're going to stay on top of the inflation in the market as it grows.

GIBBS: While it may not be any big deal for Wall Street, it does affect Main Street. I mean higher interest rates, Main Street has been monetizing their homes and now with this extra gas tax here, the rising tax is like taking money out of people's pockets. That might mean that we're not going to spend as much and retailers are worried about that, aren't they?

FARR: Retailers are worried about that, and they probably, if you have your own business, you worry about everything I think. If we are adding jobs at the rate that we have in the past couple of months - and that's an if, all right - so if we add north of 100,000, 200,000 jobs a month if this job recovery takes hold, that's a very good thing in an economic expansion, a period of economic expansion. People will have more money to spend at those retailers, even as the prices go up a little bit. But, look, the prices are going up. Food at the supermarket's more expensive. A gallon of milk, you know, almost $4.00 or $5.00 a gallon, gasoline $2.00, $2.25 a gallon. It is more expensive now, and we can digest those higher prices as a consumer if our job's solid and if we're making a little more money.

GIBBS: What is your default cash position? It's not just stuffing it in garbage bags and putting it in the drawer.

ROMICK: No, cash, we're doing commercial paper, and we'll find a certain, given our experience in high yield and stress, we'll do certain yield to call paper out there as well when we see it opportunistically. We don't spend our time doing that because we feel our time is better spent uncovering ideas and spending a lot of time doing a lot of research.

GIBBS: Michael, what are you telling your clients that may want to have a cash position but don't want to stuff it in the mattress?

FARR: Well, if you want to have a cash position because you need money to be defensive, then I think short-term instruments, and in particular short-term CDs, certificates of deposit, are showing a bit better yields for the individual investor. And rather than make some sort of long-term bet, even though 5-year CDs will pay you a much better yield, I would suggest that you keep your money short somewhere between six and 24 months, and you can put together a ladder.

Now last week's show, Karen, you explained a laddered bond portfolio. You do the same thing in a laddered CD portfolio. You divide your money up. You buy different maturities, so that your short maturities, when they come due you reinvest them out on the longer end, and as rates go up you should be able to increase the yield of your portfolio and keep your cash. And if you find something better to do with it, if you decide now's the time to get back in the stock market, you've got money coming due at different intervals that will be available to do that.

GIBBS: Let me ask you both, and I'll start with you, Michael, first, what do you think the impact of the headlines and the pictures that we're seeing coming out of Iraq are having on the individual investors' confidence level?

FARR: I think that certainly they're damaging the confidence level of individual investors. I think that they are a great weight on the spirits of most Americans. You know, one of the things that we claim is the moral high ground, and certainly we've lost a good deal of it as we look at these pictures, anything that undermines confidence, anything that keeps people from saying, "Yes, I want to buy."

People have to be confident about their job and about our country, about our situation before they go out and buy cars, before they buy the new refrigerator, or before they make those discretionary purchases and say, "I like that diamond ring and I'm going to go get that for Karen right now." I've got to feel better, and certainly the news has been very distressing.

GIBBS: Steven?

ROMICK: I don't have a lot to add. I mean, the pictures are horrifying. They're spiritually disappointing. I mean how it affects investors specifically, I don't know. Honestly, I look at investors out there and I think they're guided by the recent returns of the market. And I mean with all the mutual fund scandals that have been going on out there and the transgressions in the industry, you know, capital has been flowing like nothing, you know, back into equity funds because of the return.

And so I don't know specifically what the pictures that people are seeing from the acts committed against prisoners how it's impacting individual confidence, but I just don't think they're putting money back in the stock market today.

FARR: And for all the reports that we're seeing or that we're hearing about how bullish certain investors are and how bullish managers are, there's about $4.8 trillion dollars in short-term cash. There's a lot of powder on the sidelines that's not rushing into this market at all.