Five Market Insights from George Soros

George Soros is a living legend among traders. With a net worth of $28 Billion, he is the richest market speculator in the world, after Buffett. What’s interesting is that he started his hedge fund when he was 42 years old. His proteges share that his batting average is terrible. They say he has been right about 30% of the time, but when he is right, he’s right and he makes sure to fully capitalize on it. His trading philosophy could be best described with two phrases:

“It doesn’t matter if you are right or wrong, but how much money you make when you are right, and how much money you lose when you are wrong”

“When you have a tremendous conviction on a trade, you have to go for the jugular. When you are right on something, you can’t own enough”.

Here are a few more tidbits that reveal how Soros thinks about financial markets:

Perceptions affect prices and prices affect perceptions

I believe that market prices are always wrong in the sense that they present a biased view of the future. But distortion works in both directions: not only do market participants operate with a bias, but their bias can also influence the course of events.

For instance, the stock market is generally believed to anticipate recessions, it would be more correct to say that it can help to precipitate them. Thus I replace the assertion that markets are always right with two others: I) Markets are always biased in one direction or another; II) Markets can influence the events that they anticipate.

As long as the bias is self-reinforcing, expectations rise even faster than stock prices.

Nowhere is the role of expectations more clearly visible than in financial markets. Buy and sell decisions are based on expectations about future prices, and future prices, in turn are contingent on present buy and sell decisions.

On Reflexivity

Fundamental analysis seeks to establish how underlying values are reflected in stock prices, whereas the theory of reflexivity shows how stock prices can influence underlying values. One provides a static picture, the other a dynamic one.

Financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions, that financial markets perform, work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified.

On bubbles

When I see a bubble forming, I rush in to buy, adding fuel to the fire. That is not irrational.

Boom-bust processes are asymmetric in shape: a long, gradually accelerating boom is followed by a short and sharp bust. The bust is short and steep because it involves the forced liquidation of unsound positions.

First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times, it is quite pronounced. When there is a significant divergence between market prices and the underlying reality, there is a lack of equilibrium conditions.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia.As Chuck Prince, former head of Citigroup, said, ‘As long as the music is playing, you’ve got to get up and dance. We are still dancing.’ Eventually, a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

On trend following

Once a trend is established it tends to persist and to run its full course.

Currency movements tend to overshoot because of trend-following speculation, and we can observe similar trend-following behaviour in stock, commodity and real estate markets, of which Dutch Tulip Mania was the prototype.

When a long-term trend loses its momentum, short-term volatility tends to rise. It is easy to see why that should be so: the trend-following crowd is disoriented.

Markets might be forward-looking, but they are not always right

How good are markets at predicting real-world developments? Reading the record, it is striking how many calamities that I anticipated did not in fact materialise.

Financial markets constantly anticipate events, both on the positive and on the negative side, which fail to materialise exactly because they have been anticipated.

It is an old joke that the stock market has predicted seven of the last two recessions. Markets are often wrong.

It doesn’t hurt you what you don’t know, but what you think you know, when it ain’t so

Participants act not on the basis of their best interests but on their perception of their best interests, and the two are not identical.

 

On Manipulation

I want to buy $300 million of bonds, so start by selling $50 million. I want to see what the market feels like first.

On how to be selectively active

The trouble with you, Byron [Byron Wein – Morgan Stanley], is that you go to work every day [and think] you should do something. I don’t, I only go to work on the days that make sense to go to work. And I really do something on that day. But you go to work and you do something every day and you don’t realise when it’s a special day.

Five Market Insights from Paul Tudor Jones

Paul Tudor Jones is one of the most emblematic figures in the hedge fund industry. His best percentage returns happened during severe market corrections: 126% after fees in 1987 when U.S. markets lost a quarter of their market cap in one day. 87% in 1990 when the Japanese stock market plunged. 48% during the tech crash of 2000-2001. He returned 5% in 2008. His funds have underperformed in the past 8 years. He charges 2.75% management fee and 27% performance fee, which significantly above the industry average of 2 and 20.

Outside of financial markets. PTJ founded the Robin Hood foundation, which attempts to alleviate problems caused by poverty in NYC.

The biggest conundrum when studying successful money managers is do you pay attention to what they are doing today or do you focus on what they were doing before they became widely popular, were managing a lot less money and had a lot higher returns?

Here PTJ talks about how new powerful trends often start – basically, a big price expansion from a long base.

The basic premise of the system is that markets move sharply when they move. If there is a sudden range expansion in a market that has been trading narrowly, human nature is to try to fade that price move. When you get a range expansion, the market is sending you a very loud, clear signal that the market is getting ready to move in the direction of that expansion.

PTJ on risk management

If I have positions going against me, I get right out; if they are going for me, I keep them… Risk control is the most important thing in trading. If you have a losing position that is making you uncomfortable, the solution is very simple: Get out, because you can always get back in.

I am not sure he can do that today with the size he is trading. The approach that made him an investing legend might not be the approach that he is using today. He is trading a lot more money and size can change everything, especially when you trade other people’s money.

PTJ is famous for the saying “losers average down losers” and yet if you look at his hedge fund’s record, he dollar-cost averages all the time. Again, the size of his fund has forced him to change his market approach. You can’t just get in and out from a billion dollar position whenever you decide to. There’s not enough liquidity and if you don’t invest enough in your best setups, you are guaranteed to underperform after management fees. It is normal to ladder in and out when you trade with size.

When you are trading size, you have to get out when the market lets you out, not when you want to get out.

That cotton trade was almost the deal breaker for me. It was at that point that I said, ‘Mr. Stupid, why risk everything on one trade? Why not make your life a pursuit of happiness rather than pain?’

Another popular speculator, Jim Rogers is often quoted saying that “he has never met a rich technician”. Well, here’s PTJ on the value of technical analysis:

Markets have consistently experienced “100-year events” every five years. While I spend a significant amount of my time on analytics and collecting fundamental information, at the end of the day, I am a slave to the tape and proud of it.

I see the younger generation hampered by the need to understand and rationalize why something should go up or down. Usually, by the time that becomes self-evident, the move is already over.

When I got into the business, there was so little information on fundamentals, and what little information one could get was largely imperfect. We learned just to go with the chart. Why work when Mr. Market can do it for you? These days, there are many more deep intellectuals in the business, and that, coupled with the explosion of information on the Internet, creates an illusion that there is an explanation for everything and that the primary task is simply to find that explanation. As a result, technical analysis is at the bottom of the study list for many of the younger generation, particularly since the skill often requires them to close their eyes and trust price action. The pain of gain is just too overwhelming to bear.

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I teach an undergrad class at the University of Virginia, and I tell my students, “I’m going to save you from going to business school.  Here, you’re getting a $100k class, and I’m going to give it to you in two thoughts, okay?  You don’t need to go to business school; you’ve only got to remember two things.  The first is, you always want to be with whatever the predomianat trend is.

My metric for everything I look at is the 200-day moving average of closing prices.  I’ve seen too many things go to zero, stocks and commodities.  The whole trick in investing is: “How do I keep from losing everything?”  If you use the 200-day moving average rule, then you get out.  You play defense, and you get out.

Trading manias and crashes cannot be taught. It can only be experienced:

There is no training — classroom or otherwise — that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market. There’s typically no logic to it; irrationality reigns supreme, and no class can teach what to do during that brief, volatile reign. The only way to learn how to trade during that last, exquisite third of a move is to do it, or, more precisely, live it. Fundamentals might be good for the first third or first 50 or 60 percent of a move, but the last third of a great bull market is typically a blow-off, whereas the mania runs wild and prices go parabolic.

He looks for great risk/reward setups. Sometimes, those setups are near market’s major turning points:

I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward-risk opportunities that should give you minimum draw down pain and maximum upside opportunities.

I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.

Five Market Insights from Christian Siva-Jothy

Christian Siva-Jothy was Goldman Sachs Group Inc.’s co-head of proprietary currency trading until 2004, when he launched his own SempreMacro fund. He closed his fund in 2011 after losing 27% in 2009 and 8.7% in 2010.

Here’s Siva-Jothy on why he closed his fund:

In this business you are only as good as your last few trades,” Siva-Jothy wrote. “Mine have not been very good. Whether I have lost my edge or simply need a break after 23 years I am not sure, but I certainly hope it is the latter.

No one gets paid for originality

Generally, I can’t see more than a year ahead because things change so rapidly it is very difficult to have a 5- to a 10-year view. I have a rolling one-year view of the world and I impose discipline on myself by keeping a trading diary. Every morning, I go through the same process: If I have any positions on, I ask why do I have the positions? What has changed?

Putting on positions because someone really smart that you respect has it on is a recipe for disaster because you don’t know why you got in or where to get out.

No one gets paid for originality — you get paid for making money.  I am happy to take other people’s good ideas and run with them, AS LONG AS I UNDERSTAND EXACTLY WHY I AM IN THE TRADE.

The way to make money is to chip away at small trades and then lever up when something big comes up.

I am a great believer that there are three or four major macro opportunities every year. If you catch one, your return will be in the high single digits; if you catch two, you should be up somewhere between 10 and 20 percent; if you catch three or four, you are doing incredibly well.

One of the most difficult things about trading is not to trade. That’s probably one of the most common mistakes that people starting out in this business make. Overtrading is as bad as running losing positions for too long.

On how to manage risk

To me, risk is about liquidity, and that is one of the reasons why I am never short gamma.

Markets can be unbelievably slow to figure out the consequences of big events that there’s no script for.

Implied volatilities are always massively undervalued during big events.

I learned not only not to sell options, but to actively look for options to purchase in times of stress and dislocation.

History can be a useful benchmark but only if everything is put into the right context

People spend far too much time saying things like, “This is what happened in 1987 and this looks very similar so I’ll put the same trade on” or “This is what happened in 1994 when the tightening cycle started; therefore the same thing is going to happen this time.”. I don’t like this approach. Markets are dynamic and people’s reactions are different. It’s much more subtle and nuanced that looking at what happened the last time.

Risk more only when you have won your right to do so

My philosophy has always been to trade up when things are going well and you have a high-confidence view. There’s a big difference between going from 30% to 20%, and going from zero to -10%.

From zero to minus 10% is an unbelievably meaningful drawdown. On the other hand, if we are up 30-40%, I am not going to be worried about a 10% drawdown as long as we’re being rigorous.

Confidence is a very, very dangerous thing. Simply because you’ve had a god run doesn’t mean it will continue. In fact, once you’ve had a good run, you’re at your most dangerous. Markets can take it aways as easily as they give it.

Source: Inside the House of Money, Steven Drobney

Five Market Insights from David Tepper

David Tepper has been one of the most followed and admired hedge fund managers for the past decade. He has the folksy wisdom of Warren Buffett, the analytical deepness of Jim Rogers, and the trading acumen of George Soros. He launched his fund Appaloosa in 1993 with $7 million of his own and $50 million outside money. Since then, he has averaged an annual return of 30% after fees. He invests in high yield bonds, distressed debt, and equities in the U.S. and emerging markets.

Tepper explains his investing philosophy with the phrases “trees grow” and “Those who keep their heads while others are panicking do well.” In other words, growth is natural and optimism tend to get rewarded over time. He is accustomed to invest a large portion of his portfolio into a single idea.

Tepper made most of his money out of the recoveries from big market corrections – emerging markets in 1997, the tech crash in 2000-2002, the financial crisis in 2008. Not during, after. His fund lost 25% in 2008. Made 120% after fees in 2009.

Big corrections create big opportunities. As Peter Lynch said a long time ago, “It is not entirely clear what causes deep market corrections, but without them, many of the best performing long-term investors would have never achieved their spectacular returns.”

It seems Tepper’s market approach has changed from being a trend follower to being a deep value investor. He was short going into the 1987 crash.

Going into the crash I had set up my entire portfolio as just short – I had no long positions. I made a fortune during and after the crash. It was very cool.

We don’t really buy high-flyers. We buy before they get high-flyers.

Patience and Confidence to act on your own analysis are key.

The main thing that makes Appaloosa stand apart from the pack is the depth of our analysis and the fact that we’re not afraid to be the first one to act on our convictions. If you look at our history over the years, we are usually the first mover in a country or situation, time and time again.

For better or worse we’re a herd leader. We’re at the front of the pack, we are one of the first movers. First movers are interesting, you get to the good grass first, or sometimes the lion eats you.

We’re value-oriented and performance-based like a lot of funds. But I think what differentiates us is that we’re not afraid of the downside of different situations when we’ve done the analysis. Some other people are very afraid of losing money, which keeps them from making money.

Tepper likes to replay his losses in his head:

It is the only way you learn from your mistakes.

Tepper says that losing 29% ($80 million) on Russia when Russia defaulted after an IMF deal “the biggest screw-up in his career”.

I’ve made a lot of bad trades.

The worst trade we’ve made was probably in 1998. It was Russia and we thought Russia could devalue but they wouldn’t default. But they did both. So we kind of miscalculated that. We were too long and I couldn’t get out of that trade. We were down 20 something percent.

We had huge emerging market and junk positions that we sold down to avoid disaster, so we were able to act fast. Our biggest mistake was not realizing how illiquid markets could get so quickly. Many firms went out of business at the time, and at one point, I wondered if we would be able to survive. That was kind of an interesting lesson for a lot of people.

Tepper bought back Russian bonds after the default in 1999 at five cents on the dollar. He made 61% on that trade:

It was like minting money. It was almost worth all the hell we had to go through.

Size matters. The amount of capital you manage can impact your approach significantly. Tepper routinely returns principle and profits to his investors after a strong year.

The question is what size gets you – except more fees for the manager. But it doesn’t necessarily make the investor more money.

Fixed income funds should naturally be a little bit larger than, say, equity funds. You want to be big enough that you can see everything and small enough that you don’t kill yourself with size. So I think different sizes are right for different types of funds.

Say you want to buy 5 percent of a $2 billion company, and have it be meaningful. That means it’s a 1 percent position in a $10 billion fund. So if you’re an equity fund, if you keep getting bigger and get to $20 billion, that means your position is now only a half percent position. The 1 percent position doesn’t do much for the fund and so the half percent position does half as much. So there’s an aspect to the business, in equity funds especially, that gets funky on size.

No market approach works all the time. There are times to be aggressive and there are times to sit and wait.

Sometimes it’s time to make money, sometimes it’s time not to lose money.

The key is to wait. Sometimes the hardest thing to do is to do nothing.

Tepper keeps a brass replica of a pair of testicles in a prominent spot on his desk, a present from former employees. He rubs the gift for luck during the trading day to get a laugh out of colleagues.

The media says that hedge funds are the new masters of the universe… We’re just a bunch of schmucks.

Tepper is also famous for his charity work:

The more I make, the more I’ll give away.

Five Market Insights from Scott Bessent

Scott Bessent is probably the only one in the world who worked with investing legends like Jim Rogers, Jim Chanos, George Soros, and Stanley Druckenmiller in different stages of his career. He oversaw Soros’s $30-billion fortune between 2011 and 2015. Last year, he launched his own fund. Here are some of his more interesting market insights:

Short-selling is a unique and specific mindset

I went to work with Jim Chanos, who just did short selling. Jim was always trying to go against the crowd. He constantly picked things apart and looked for what the market had wrong.
One thing Jim was never great at was figuring out why it would end. He never really looked for the catalyst that would change the market’s focus. He was usually right, but what I’ve learned since is that it’s more important to be there when a mania ends, that spotting it early.
What I came away with from my time with Chanos was that you don’t have to be skeptical about everything.
There are also other problems with shorting. There’s a difference between investing or buying stocks and shorting. If you are a long/short player and one of your longs goes down 10 or 20 percent, you’ll buy more. If one of your shorts goes up 10 or 20%, you’ll get out.

On how Soros and Druckenmiller “broke” the Bank of England

The breaking of the pound was a combination of Stan Druckenmiller’s gamesmanship – Stan really understands risk and reward — and George’s ability to size trades. Make no mistake about it, shorting the pound was Stan’s idea. Soros’s contribution was pushing him to take a gigantic position.
With the pound, we realized that we could push the Bank of England up against the trading band where they had to buy an unlimited amount of pounds from us. The plan was to trade the fund’s profits and leverage up at the band’s boundary. The fund was up about 12 percent for the year at the time, so we levered the trade up to the point where if they pushed us back up against the other side of the trading band, we would lose the year’s P&L but not more.
The UK economy was already weak, so when they raised interest rates to defend the currency, the average person’s mortgage went up. They basically squeezed everyone in the UK with a mortgage. When they raised rates from 7% to 12% with the stated goal of defending the pound, we knew it was unsustainable and they were finished.

On his worst trade

Being short Internet stocks too early in 1999. Right trade, wrong time. It taught me the lesson that you can be right and lose all your money. Also, if a stock is going to zero it doesn’t matter where you short it, you’re still going to make 100% because you can short on the way down. You made just as much money shorting $100 million in Enron at $25 as you did shorting $100m at $50. it ‘s better to have more conviction and do twice as much.

Stock Picking is full of macro bets

Recently, I was at a money manager roundtable dinner where everyone was talking about “my stock this” and “my stock that”. Their attitude was that it doesn’t matter what is going to happen in the world because their favorite stock is generating free cash flow, buying back shares, and doing XYZ. People always forget that 50% of a stock’s move in the overall market, 30% is the industry group, and then maybe 20% is the extra alpha from stock picking. And stock picking is full of macro bets. When an equity guy is playing airlines, he’s making an embedded macro call on oil.

In trading, when there’s nothing to do, the best thing to do is nothing

Soros used to give out a lot of money for other people to manage. George wasn’t bothered when people started losing money, but he was always worried that they weren’t feeling the pain properly because it was his money and not theirs. If people managing his money were down in November or December and he saw their trades getting bigger, he’d pull the money immediately. Also, if the manager was down and their trading volume picked up dramatically, he’d pull it. The worst thing you can do when you are having a hard time is flail. In trading, when there’s nothing to do, the best thing to do is nothing.

Source: Inside the House of Money, Steven Drobny