Dow Dangers

If you didn’t pay close attention to Steve Chapman when I interviewed him here in the Money and Markets two months ago, you may want to listen more carefully now.

He named the mutual funds he was favoring, and each of those has risen significantly since. Plus, he said he was avoiding investments in the broad U.S. stock indexes like the S&P 500 or the Dow Jones Industrials; and sure enough, those indexes are now showing signs of breaking down.

Consider the S&P. On Thursday night, it closed within a hairline — less than a point — from its lowest level of the past half year.

Now, if it declines just a couple of points more, it would break through that low. That would mean nearly all investors who bought into the broad market over the past six months are likely to be under water. That’s a potentially powerful psychological factor that could add to the selling pressure and drive stock prices still lower.

The prognosis for the Dow Jones Industrials is equally worrisome, especially if you look back a bit further in time.

Starting in early March, the Dow plunged by over 900 points in just six weeks, a warning sign of possible danger ahead.

Then, in an attempt to recover, it began a zigzag rally which lasted for about four months.

If that rally could have gathered enough steam, it might have been a good omen for investors. But it was labored and protracted. And it’s now breaking down, raising the specter of another Dow decline that could be similar to the 900-point plunge of March and April.

As Vice President of our separate affiliate, Weiss Capital Management, Steve Chapman’s views are not necessarily the same as ours in Money and Markets. Nor does he always agree with me about the timing and direction of the stock market.

But in a broad sense, he has a similar investment philosophy. And for the past year, his primary investment focus has been in some of the same areas we have been highlighting here: Energy, natural resources and international markets.

Steve works out of Weiss Capital Management’s separate facility near the PGA Resort, and yesterday afternoon, he visited our offices in Jupiter. So I decided to follow up on our interview published here on August 10 (Subject line: Surging Commodity Prices).

What to do in an
Energy Market Correction
Interview with Steve Chapman,
Vice President and Portfolio Manager,
Weiss Capital Management

Martin Weiss: Last time we spoke, you named some of the mutual funds you had your clients in at the time: Eaton Vance Asian Small Companies (EVASX), Fidelity Select Energy (FSENX), Oppenheimer Int’l Small Company (OSMAX) and MFS Emerging Market Debt (MEDAX). What’s your position with these funds right now?

Steve Chapman: No change. The clients in our All Star Growth program owned them then, and they own them now. My philosophy is simple: These funds have delivered outstanding performance. So as long as that pattern continues, I stay the course. Why fix it if it ain’t broke?

Martin: This week, though, the energy sector suffered a correction. And earlier this week, some international markets — in Asia and Latin America, for example — have taken some hits. How does that fit into your strategy?

Steve: This isn’t the first time we’ve had a similar pullback since we launched this program 14 months ago. Nor do I think it will be the last. And until I see a fundamental change in the trend, I am going to respond the same way as I did the last time: I’m going to use the pullbacks as a buying opportunity for new clients. And I’m going to use it as a buying opportunity for clients that are adding new funds to their accounts.

Martin: How do you separate in your mind a fundamental trend change from a temporary correction?

Steve: With common sense. Take the oil market, for example. There are two possible reasons why the oil market might suffer a decline.

One could be that oil and gas prices simply went too far, too fast. So the markets do what they always do — they back and fill, consolidate and prepare for the next major move. Today’s ceiling often becomes tomorrow’s floor.

The other reason could be that people’s habits are actually changing. They’re driving less, flying less and conserving energy. Then, you’re talking about a potentially longer lasting decline in the oil markets.

Martin: And you don’t see that happening at this juncture?

Steve: Not at all. We have no evidence yet of a fundamental change in habits. New car buyers may be favoring cars with better gas mileage. But the overwhelming majority of Americans are driving the same cars they drove months ago, the same distances and in the same way. So my view is that the oil price decline you’ve seen in recent days is just one of those natural market fluctuations.

Martin: What’s it going to take to get fuel prices down for good, then?

Steve: First, they’re going to have to rebuild the rigs in the Gulf of Mexico that were wrecked by the hurricanes. That isn’t going to be quick or cheap. It’s going to take time. It’s going to require a lot of steel, copper tubing, cement, and other construction materials. And besides, it’s going to cost. They’re going to have to pay through the nose for those commodities.

Second, refining capacity and supply would have to increase markedly or at least enough to satisfy growing demand. I don’t see that happening any time soon.

Martin: So right now you’re standing pat with Fidelity Select Energy?

Steve: Yes. Plus, I’m continuing to diversify to a broader base of commodities that are not directly correlated to the ups and downs in oil. I’m looking at one fund in particular that includes base metals, cement, and lumber. It’s a good play on the Katrina and Rita recovery efforts. Plus, in a way, it acts as a hedge for oil, but still in commodities.

Martin: Why do you believe commodities are going to continue higher?

Steve: Tight supplies and unbridled demand. This is not just economic theory. It’s a phenomenon you can see for yourself, with your own eyes.

One of my best friends, for example, is in the construction business, and he’s building his own house. He tried to order the lumber from Boise Cascade. None available. He went to Union Pacific. Same response.

Do you know where he finally got the lumber? In Brazil. He ordered it on the Internet and got it drop-shipped to his property. The deal is that the exporter doesn’t charge his credit card until they get confirmation of delivery.

Cement? Same problem. Unless you want to take a number and get on a long line, it’s almost impossible to get delivery for cement from U.S. sources, especially for smaller jobs. So he got his from Cemex in Mexico. Also on the Internet.

This just goes to show how tight raw materials supplies are in the United States. Plus, it’s another reminder of the great potential for investing in overseas companies.

Martin: Some people say this is all due to Katrina and Rita. What’s your response to that?

Steve: It may be. But that’s no temporary situation. From what we can see right now, there’s no end in sight to these supply shortages. Besides, we were seeing the same thing earlier this year, long before the hurricane season began.

Martin: Where else are you putting investors’ money.

Japan and India

Steve: I’m currently looking at Japan. While the U.S. market has been sagging, the Japanese market has been surging. And as the Japanese economy recovers, I think the companies that will lead the way are their small caps. That’s what happened here in the United States. And that’s what seems to be happening now in Japan as well.

Martin: So you’re starting to get into Japan now?

Steve: No. I’ve had a stake in Japan through a couple of the Asian funds I already have in our clients’ accounts. Now, I’m looking to step in a bit more directly with a fund that’s specialized in Japan’s small caps. Plus, I still like China and India also.

Martin: Last time you told us why you like India. For the sake of readers who may have missed it, can you give us your reasons again?

Steve: It boasts the largest, highly educated, lowest-cost, English-speaking work force in the world. I think that’s even better than Japan’s work force at the dawn of its postwar boom. I think it’s even better than the Chinese workforce that’s had such an impact on the world economy in this decade.

Plus, I think the Chinese revaluation of the yuan, however small, is bound to have a substantial spill-over effect on India.

Martin: Because Indian goods will now be more competitive than Chinese goods?

Steve: Yes. But also because China itself will be buying from India, as a mega-customer.

Martin: And to invest in India, you are using …

Steve: Eaton Vance Asian Small Companies plus the Oppenheimer International Small Company Fund. Year to date, they’re both up 25%.

Ready for a Decline

Martin: All this raises a very important question: Suppose the Dow plunges another 1,000 points. Suppose all U.S. stock indexes crash. Wouldn’t that drag down even the strongest sectors and the strongest foreign markets?

Steve: Probably. But that’s why investors hire Weiss Capital Management to manage their money. That’s why we watch over their accounts every hour of the trading day, every trading day of the week. When investments are not performing, we aim to move on to those that are.

Take MFS Emerging Market Debt (MEDAX), for example, one of the funds I told you about last time. It’s not risk free. But it’s designed to give you what I call “stock-like returns for bond-like risks.” In other words, it offers the total return potential of stocks with the relatively reduced risk of a bond. Plus, the average duration of the fund is relatively short. When stocks are not performing, this is the kind of fund I will be moving into.

Plus, never forget cash or equivalent. Most managers think their job is to always keep nearly all of their client’s money invested. So they wind up holding and holding even while the markets are falling and falling. I don’t agree with that strategy.

Naturally, losses are always possible. But our role is to actively manage with the goal of minimizing the downside risk.

No End in Sight to
Commodity Boom

Martin: Last time you talked about surging commodities and the massive demand from developing countries. But now with prices much higher today, do you think some of those countries will still be able to afford to grow as quickly as they have been?

Steve: That’s why China is now on a quest to control their own energy sources, to gain better control over their costs and their own destiny. Their reasoning is very basic: Own the farm and save on the grocer.

Remember: These countries with big populations and big population growth are not just growing. They’re modernizing. They’re not just going to need more food. They’re going to want more cars, driving up the demand for metals and gasoline. They’re going to want more homes, driving up the demand for lumber and cement. The kind of demand growth you normally see in years is happening in months.

Martin: And if it the trend changes unexpectedly?

Steve: That’s why investors should diversify. No matter what trend is hot right now, you’ve got to stay on the look-out for the next major trend. You can’t fall in love with any particular sector or investment.

34.4% Portfolio Growth

Martin: Is your program dedicated exclusively to energy, commodities and international?

Steve: Since inception, they’ve been my major concentrations and they’re largely responsible for our performance to date. But I’m not married to them, and I also have some exposure to other sectors.

Martin: Can you give us more info on your performance?

Steve: In the third quarter, our All Star Growth program is up 10.7%. Year to date, we’re up 14.8%. And since inception —August 6 of last year — we’re up 34.4%. Annualized, that’s 26.4%.

Martin: Is that net of all of your fees and all of the broker’s commissions?

Steve: Yes. That’s the net, net return to the investor.

Martin: And those figures are updated through …

Steve: September 30, 2005.

Martin: Any major change since then?

Steve: No.

Martin: So an investor who began with you at the outset would now be up about 34%?

Steve: Yes, including all dividends and reinvestment of dividends. I hasten to add, though, that’s all in the past. You can’t hop on a time machine and start investing with us on August 6, 2004. The future, meanwhile, is always uncertain when it comes to investing. We could continue on the same course. We could do better. We could do worse. Or we could go in the opposite direction, and our clients could lose money.

Martin: Understood. But from what I recall from our last interview, some of the funds you use are load funds. Like the two Asian funds you said are up 25%, for example. They charge loads, right? So how do you achieve that kind of high performance if the client is paying a large fee to get into funds that you may not be holding for a long time?

Steve: Our managed clients do not pay the loads. That’s one of the advantages of this program, one of the advantages of using us as your adviser. The reason is we’re participating in a “no-transaction-fee” mutual fund platform. So our clients can get access to many of the best mutual funds and to some of the most highly qualified portfolio managers. All with no load.

Martin: No fees?

Steve: No, I didn’t say that. We still charge our management fee. That’s the only way we get paid. But our annual fee is far less than the one-time loads you’d have to pay if you bought the fund shares directly yourself. Besides, the 34.4% cumulative performance from inception through September 30 is net of all fees.

Martin: Can you explain a bit more how it works?

Steve: In this program, I don’t pick individual stocks. I pick what I consider the best mutual funds with the best portfolio managers in the areas or sectors I like the best. They pick the individual stocks.

In other words, my role is to monitor and manage the managers. And for me, beating the so-called “benchmarks” isn’t enough.

Martin: Please elaborate.

Steve: I want positive performance. For example, a small-cap specialist could be beating all of his benchmarks for small caps and doing a great job of it. But if the whole small-cap sector is down, it’s no victory for the client.

The sector could be down, say, 30% and the manager could be down only 10%. So he’s beating his benchmark by 20 percentage points. That’s supposed to be “great.” But for the investor, it’s a defeat. Your goal should be to make money — not to lose less money.

Martin: Of course. Where can investors get more information?

Steve: On our Weiss All-Star Growth web page. Or just give us a call at 800-814-3045.

Martin: OK. Please let us know when you see any major change — so we can talk about this again.

Views expressed by Steve Chapman in this interview are his solely.

© 2005 by Weiss Research, Inc. All rights reserved.
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