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The Science of Hitting
The Science of Hitting
Articles (524) 

Speculating in Bubbles With Stan Druckenmiller and Sir Isaac Newton

November 20, 2014

Last November, Stanley Druckenmiller appeared in a lengthy interview on Bloomberg (here). In that interview, he discussed his experience during the tech bubble:

“I bought the top of the tech market in March of 2000 [after quickly making money in the same space in mid-late 1999] in an emotional fit I had because I couldn’t stand the fact that it was going up so much and it violated every rule I learned in 25 years. … I bought the tech market very well in mid-1999 and sold everything out in January and was sitting pretty; and I had two internal managers who were making about 5% a day and I just couldn’t stand it. And I put billions of dollars in within hours of the top. And, boy, did I get killed the next couple months.”

A Wall Street Journal article (here) from that time covers just what “killed” means:

“When the sell-off finally did begin in mid-March, Soros Fund Management wasn't ready for it. Still loaded with high-tech and biotechnology stocks and still betting against the so-called Old Economy, Soros traders watched in horror when the tech-heavy NASDAQ Composite Index plunged 124 points on March 15 while the once-quiescent Dow Jones Industrial Average leapt 320 points. In just five subsequent days, the Soros firm's flagship Quantum Fund saw what had been a 2% year-to-date gain turn into an 11% loss… By the end of April, the Quantum Fund was down 22% since the start of the year, and the smaller Quota Fund was down 32%.”

The most shocking part of the story is that they weren’t blindsided by this development: internally, managers at Soros Fund Management (including Mr. Druckenmiller) had been predicting the “inevitable sell-off of technology stocks” – one that “could be near and could be brutal.” And yet, their final conclusion was to bet billions and billions of dollars on technology stocks; the allure of making “easy” money outweighed how illogical they all knew it really was.

Mr. Druckenmiller’s actions in the late 1990s/early 2000s are reminiscent of Isaac Newton during the South Sea Bubble (from a 2009 article by MIT professor Thomas Levinson – here):

Starting at £128 in January, the price for South Sea securities rose to £175 in February and then £330 in March. Newton kept his head at first. He sold in April, content with his (quite spectacular) gains to date. But then, between April and June, share prices tripled, reaching over £1,000 ... which is precisely when he could stand it no longer. Having "lost" two-thirds of his potential gain, Newton bought again at the very top, and bought more after a slight decline in July… The bubble burst, and South Sea share prices collapsed to roughly their pre-bubble level. Newton's losses totaled as much as £20,000, between $4 million and $5 million in 21st-century terms. … After the disaster, he could not bear to hear the phrase "South Sea" mentioned in his presence. But just once he admitted that while he knew how to predict the motions of the cosmos, “he could not calculate the madness of the people.”

I’m simply astounded to see such brilliant people act in a way that is so wonderfully illogical. Both investors couldn’t stand to watch as others made money – and they went back in with full knowledge that they were purely speculating (we know from Druckenmiller’s words that he didn’t think these companies were cheap; we can presume the same with Newton considering he had sold the same securities a few months earlier at roughly one-third of their current price).

If you’re like me, you’ve been a net seller of stocks as valuations have become more optimistic; as equity markets have continued higher, that means cash has been a pretty significant drag on returns. In these scenarios, it seems like the “opportunity cost” is consistently on the rise; as I noted in an article a few months back, I think the opposite is true:

Although it appears that cash becomes an increasingly expensive alternative to equities as markets roar higher, the reality is the exact opposite; future rates of return are being sacrificed for current gains, a trade-off that acts like a rubber band as its stretched further and further from equilibrium (only to come shooting past balance to the other extreme at some point down the road). Those who fail to recognize this undeniable truth are most susceptible to becoming its ultimate victim.

I have no interest in betting on equity movements in the near term; I think I have the skills and temperament to find a handful of winners every few years, along with a time horizon that’s different than most market participants (presenting opportunities that others, even if they see them and agree with the conclusion, will still pass on). If I can stay squarely in that arena, I think I can do well over time (and the few times I’ve drifted have usually been costly mistakes).

That likely means underperforming – possibly by a wide margin – in periods like the late 1990s; if I was back in 1720, I would’ve missed out on The South Sea Company’s historic run as well. I don’t think we’re currently on par with those periods, but we’re heading in the right direction; if that happens, it’s seems probable that investors like myself will underperform this time as well.

The time to decide whether you’re okay with that is before the frenzy begins.

If you conclude that watching other people get rich due to a vertical climb in market prices is a temptation that you simply can’t ignore, it’s best to know sooner than later; if that's the case, here’s to hoping that you’re better at timing the market than Stanley Druckenmiller (Trades, Portfolio) and Isaac Newton were.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (12 votes)

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Comments

malwan80
Malwan80 - 4 years ago    Report SPAM

i think you need to be fair and complete the full story.which is that druckenmiller turned from fully invested to shorting the market and ended the year in positive return.we should learn from druckenmiller that you need to know when you are wrong and act accordinagly.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Malwan - I know he made a 180 degree turn in 1999 (from short to long), but didn't know that was the case in 2000 (Druckenmiller didn't mention it in the interview); would you mind pointing me to a link / source? Thanks for the comment!

buffetnmunger
Buffetnmunger - 4 years ago    Report SPAM

Hopefully, people who write and read this don't make the same mistakes :)

jtdaniel
Jtdaniel premium member - 4 years ago

Hi Science,

Thank you for the good article. I am with you as a net seller over the last two years. I now have a 60% cash position in my 401(K) accounts, as the only investment options are stock and bond index funds. I plan to move much further into cash if the S%P 500 continues to rise through the end of 2014. Moving funds out of the S%P 500 in 2013/2014 has obviously hindered my returns, at least in the short run.

My taxable accounts remain almost fully invested, as I have lately averaged down into IBM. It occurs to me that the value investor's central question may now be: IBM or cash? For investors with home mortgages, vehicle loans or credit card debt, there may be a better option -- take paper profits in over-priced stocks and become debt-free. I guess it goes without saying that anyone buying stocks on margin these days is really begging for a come-uppance.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Jtdaniel - Agreed with your thinking at this point in time. On IBM, have you read Gerstner's book? I found it quite helpful in understanding the company, particularly some of the memos in the appendices. Would be interesting in hearing your thoughts on the company - thanks for the comment!

malwan80
Malwan80 - 4 years ago    Report SPAM

i am not sure what is your question exactly ,my reply was regarding that he was out of market and then entered agian at the top and then he was wrong but he shifted from long to short where he ended year positive .Secondly,Druckenmiller never had a down year ever as far as i know till he shut down his fund in 2010.so,i am not sure if you mean he lost money in the year 2000 .Finaly,i want to say that i have the at most respect for this money manager and i think Durckenmiller is underappreciated and i think he is one of the greatest money manager in history.His track record is 30.4% per year for 30 year and zero down year.

source of the pefomrance numbers is this inteview

http://www.youtube.com/watch?v=hf0wWavJz7c

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Malwan - Certainly no question that Stan Druckenmiller is among the greatest money managers in history. My question was in regards to 2000, the period addressed in the WSJ article. It's well noted that he made a major shift from short to long in 1999, and ended up for the year. In early 2000 he went long again and got hit pretty hard; he was out at Soros by April. What I was looking for is a source that suggests he did the same in 2000 as he did in 1999 - another complete 180 (in this case, back to short again); I can't find anything on that - all I know is that he left Soros in April and, after a short sabbatical, returned to Duquesne in September.

jtdaniel
Jtdaniel premium member - 4 years ago

Hi Science,

I have not yet read the Gerstner book, although I plan to - still working through a good Steve Jobs biography. As for my thoughts on IBM, the investing opportunity reminds me of Philip Morris near the end of the 1990s bull market. Virtually the entire US stock market was over-priced with the exception of one stodgy blue chip that did not capture the imagination of Wall Street or individual investors. For Philip Morris, the big issues were stigma, litigation risk, anti-smoking legislation, and the declining percentage of smokers in the US. Its share price was further depressed by the bi-furcated market near the top of the bull market, as money rapidly flowed from old economy stocks into exciting new-era companies like Dell and AOL.

During a period of easy gains, investors became indifferent to Philip Morris' great financials, shareholder- friendly management, and attractive valuation. Those who bought Philip Morris 15 years ago have no complaints today. Those who paid 100 times earnings for Cisco did not do quite as well.

How does IBM of 2014 compare to Philip Morris of 1999? It is a stodgy blue chip that a very strong market has deserted in favor of more high-profile ideas - consumer products and social networking. IBM is just out of the public eye. Compared to Philip Morris, IBM's issues are in my view easier to solve - for one thing, the government is not against it. IBM products and services are so profitably embedded in the global economy that there is no survival risk. IBM remains to some extent in transition from a hardware-based business to a software and services operation. Given the size of the business, such a fundamental change was bound to take some time. Despite the lack of revenue growth in recent years, margins and investment returns have remained strong. Wall Street, of course is treating the revenue issue as a permanent condition.

The valuation is reasonable by any objective measure. The over-riding investment question then hinges on whether management made the right decision to move from hardware toward software and services. If so, I can project from historical data that annual growth in revenue and pre-tax income should return to at least 5% for the next 10 - 20 years. Add a 2% average dividend yield and I can project a long-term 7% average annual investment return. I think this is a conservative projection, given the company's strong ROE and significant share-repurchases, as well as the potential for multiple expansion over a long holding period.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

Jtdaniel - Interesting thoughts; I need to do some more research. Thanks for the comments!

R-Vriesde
R-Vriesde - 4 years ago    Report SPAM

Hi Science, always good to revisit history. Thanks.

I've noticed one common element in all great bubbles: Once your mother in law, cleaning lady, taxi driver or gardener proudly announces their purchase of stocks, tulips, houses or gold, that's the moment to exit.

We could also look at PEs, GDP to market cap, banking leverage etc. but above seems so simple and elegant.

The Science of Hitting
The Science of Hitting - 4 years ago    Report SPAM

R-Vriesde: Agreed - when making money is easy (which occurs simultaenously with widespread interest in stocks), it's time to be cautious. Warren said it best: “The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” Thanks for the comment!

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