Category: Market Insights

Who is Stanley Druckenmiller?

Here is what hedge fund manager Scott Bessent says about Druckenmiller in the book “Inside the House of Money’:

Stan may be the greatest moneymaking machine in history. He has Jim Roger’s analytical ability, George Soros’s trading ability, and the stomach of a riverboat gambler when it comes to placing his bets. His lack of volatility is unbelievable. I think he’s had something like five down quarters in 25 years and never a down year. The Quantum record from 1989 to 2000 is really his. The assets grew from $1 billion to $20 billion over that time and the performance never suffered. Soros’s record was made on a smaller amount of money at a time when there were fewer hedge funds to compete against.

What is most interesting to me about the breaking of the pound was the combination of Stan Druckenmiller’s gamesmanship – Stan really understand risk and reward – and George’s ability to size trades. Make no mistake about it, shorting the pound was Stan Druckenmiller’s idea. Soros contribution was pushing him to take a gigantic position.

Druckenmiller is famous for making concentrated bets:

The first thing I heard when I got in the business, not from my mentor, was bulls make money, bears make money, and pigs get slaughtered. I’m here to tell you I was a pig. And I strongly believe the only way to make long-term returns in our business that are superior is by being a pig. I think diversification and all the stuff they’re teaching at business school today is probably the most misguided concept everywhere. And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to be very, very concentrated bets. They see something, they bet it, and they bet the ranch on it. And that’s kind of the way my philosophy evolved, which was if you see – only maybe one or two times a year do you see something that really, really excites you… The mistake I’d say 98% of money managers and individuals make is they feel like they got to be playing in a bunch of stuff. And if you really see it, put all your eggs in one basket and then watch the basket very carefully.

If you don’t look at it from different perspectives, you might get disillusioned that Druckenmiller recommends to always take very concentrated bets. There are some nuances that you have to consider:

1. He always has an exit strategy. When Soros and Druckenmiller made their famous bet against the British Pound, the knew exactly how much they could lose – their entire YTD gain of 12%.

Soros is also the best loss taker I’ve ever seen. He doesn’t care whether he wins or loses on a trade. If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position. There are a lot of shoes on the shelf; wear only the ones that fit. If you’re extremely confident, taking a loss doesn’t bother you.

2. He says that the right conditions to make a concentrated bet happen only once or twice a year. Not everyone is able to recognize those conditions. Proper Timing is Everything when you trade big. A good entry point allows you to go through normal market reactions.  An amazing entry point allows to use tighter stop and therefore bigger position size. Here’s hedge fund manager Scott Bessent on Stan Druckenmiller:

One of the things that I learned from Stan Druckenmiller is how to enter a trade. The great thing about Stan is that he can be wrong, but he rarely loses money because his entry point is so good.

3. You have to earn your right to bet big first.

It’s my philosophy, which has been reinforced by Mr. Soros, that when you earn the right to be aggressive, you should be aggressive. The years that you start off with a large gain are the times that you should go for it.

The way to build long-term returns is through preservation of capital and home runs. You can be far more aggressive when you’re making good profits. Many managers, once they’re up 30 or 40 percent, will book their year [i.e., trade very cautiously for the remainder of the year so as not to jeopardize the very good return that has already been realized]. The way to attain truly superior long-term returns is to grind it out until you’re up 30 or 40 percent, and then if you have the convictions, go for a 100 percent year. If you can put together a few near-100 percent years and avoid down years, then you can achieve really outstanding long-term returns.

What else, other than taking concentrated bets and impeccable timing, stay behind Druckenmiller’s exceptional performance?

A) Flexibility

The Friday before the 1987 crash, Druckenmiller goes from net short to 130% long. Here is his conversation with Jack Schwager in The New Market Wizards’ book:

– You’ve repeatedly indicated that you give a great deal of weight to technical input. With the market in a virtual free-fall at the time, didn’t the technical perspective make you apprehensive about the trade?

– A number of technical indicators suggested that the market was oversold at that juncture. Moreover, I thought that the huge price base near the 2,200 level would provide extremely strong support— at least temporarily. I figured that even if I were dead wrong, the market would not go below the 2,200 level on Monday morning. My plan was to give the long position a half-hour on Monday morning and to get out if the market failed to bounce.

***

Another important lesson to be drawn from this interview is that if you make a mistake, respond immediately! Druckenmiller made the incredible error of shifting from short to 130 percent long on the very day before the massive October 19, 1987, stock crash, yet he finished the month with a net gain. How? When he realized he was dead wrong, he liquidated his entire long position during the first hour of trading on October 19 and actually went short. Had he been less open-minded, defending his original position when confronted with contrary evidence, or had he procrastinated to see if the market would recover, he would have suffered a tremendous loss. Instead, he actually made a small profit. The ability to accept unpleasant truths (i.e., market action or events counter to one’s position) and respond decisively and without hesitation is the mark of a great trader.

***

Druckenmiller flipped the portfolio from short to long, a reversal that saved Quantum in 1999, but then hurt it a few months later in 2000. Druckenmiller finished 2000 up for the year. He went from down 12% in March to up 15% for the year in his own portfolio. If you remember, the Nasdaq dumped in March 2000 but then it almost made a marginal new high in September at which point he changed his mind again, went from net long to net short, and caught the whole move down from September to December 2000.

Stan is better at changing his mind that anybody I’ve ever seen. Maybe he stayed with it a little too long, but one of the great things about Stan is that he can and does turn on a dime. To paraphrase John Maynard Keynes, when the facts change, he changes his positions.

B) What actually matters in trading.

I’ve learned many things from Soros, but perhaps the most significant is that it’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong. The few times that Soros has ever criticized me was when I was really right on a market and didn’t maximize the opportunity

Soros has taught me that when you have tremendous conviction on a trade, you have to go for the jugular. It takes courage to be a pig. It takes courage to ride a profit with huge leverage. As far as Soros is concerned, when you’re right on something, you can’t own enough.

C) Great defense wins championships

Druckenmiller’s entire trading style runs counter to the orthodoxy of fund management. There is no logical reason why an investor (or fund manager) should be nearly fully invested in equities at all times. If an investor’s analysis points to the probability of an impending bear market, he or she should move entirely to cash and possibly even a net short position.

D) You could be right on a market and still end up losing if you use excessive leverage.

One basic market truth (or, perhaps more accurately, one basic truth about human nature) is that you can’t win if you have to win. Druckenmiller’s plunge into T-bill futures in a desperate attempt to save his firm from financial ruin provides a classic example. Even though he bought T-bill futures within one week of their all-time low (you can’t pick a trade much better than that), he lost all his money. The very need to win poisoned the trade— in this instance, through grossly excessive leverage and a lack of planning. The market is a stern master that seldom tolerates the carelessness associated with trades born of desperation.

Sources:

INSIDE THE HOUSE OF MONEY, STEVEN DROBNEY, WILEY, 2008
Schwager, Jack D. (2009-10-13). The New Market Wizards: Conversations with America’s Top Traders. HarperBusiness.

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.

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.

***

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.