The New Market Wizards: Conversations with America's Top Traders (26 page)

I said, “What else am I going to do? Frankly, I think I’m lucky to be there, given the level of my experience.”

After about two minutes of talking, he asked, “Why don’t you start your own firm?”

“How can I possibly do that?” I asked. “I don’t have any money.”

“If you start your own firm,” he replied, “I’ll pay you $10,000 a month just to speak to you. You don’t even have to write any reports.”

To put this in perspective, when I started at the bank in 1977, I was making $900 a month. When I was promoted to the research director position, my annual salary was still only $23,000, and all the analysts who reported to me were making more than I was. Even after my promotion to Drelles’s position, I was still earning only $48,000 a year. In this context, the offer of $10,000 a month, not counting the money I could potentially earn on managing funds, seemed extremely attractive. I figured that even if I fell completely on my face, I could still get another job that would pay more than I was making at the bank.

In February 1981, with one other analyst and a secretary, I launched Duquesne Capital Management. We began with $1 million under management, which generated $10,000 per year in fees. Most of our income came from the $10,000 per month consulting fee arrangement. We started off extremely well, catching the sharp upmove in low cap stocks. By mid-1981, stocks were up to the top of their valuation range, while at the same time, interest rates had soared to 19 percent. It was one of the more obvious sell situations in the history of the market. We went into a 50 percent cash position, which, at the time, I thought represented a really dramatic step. Then we got obliterated in the third quarter of 1981.

I don’t understand. How did you get obliterated if you went into a 50 percent cash position?

Well, we got obliterated on the 50 percent position we still held.

Yes, but you would have lost only half as much as everyone else.

At the bank, the standard procedure had been to always be nearly fully invested. Although I wasn’t working for a bank anymore, I had obviously still maintained some of this same mentality. You have to understand that I was unbelievably bearish in June 1981. I was absolutely right in that opinion, but we still ended up losing 12 percent during the third quarter. I said to my partner, “This is criminal. We have never felt more strongly about anything than the bear side of this market and yet we ended up down for the quarter.” Right then and there, we changed our investment philosophy so that if we ever felt that bearish about the market again we would go to a 100 percent cash position.

During the fourth quarter of 1981, the stock market partially rebounded. We were still extremely bearish at that point, and we dumped our entire stock position. We placed 50 percent in cash and 50 percent in long bonds. We loved the long bond position because it was yielding 15 percent, the Fed was extremely tight, and inflation was already coming down sharply. It seemed like a gift.

We did very well, and by May 1982 our assets under management had grown to $7 million. One morning, I came into work and discovered that Drysdale Securities—our consulting client—had gone belly-up. I immediately called my contact at the firm, but he was no longer there.

I realized that I had an immediate problem. My overhead was $180,000 per year and my new revenue base was only $70,000 (1 percent on the $7 million we managed). I had no idea how we could possibly survive. At the time, our firm had assets of just under $50,000, and I was absolutely convinced that interest rates were coming down. I took all of the firm’s capital and put it into T-bill futures. In four days, I lost everything. The irony is that less than a week after we went bust, interest rates hit their high for the entire cycle. They’ve never been that high since. That was when I learned that you could be right on a market and still end up losing if you use excessive leverage.

At the time, I had a client who had sold out a software company at a very young age. He had given the proceeds from this sale, which were quite substantial, to a broker who lost half the amount in the options market. In desperation, this broker had brought him to me, and I ended up doing extremely well for the account. Since it was an individual account, whereas all my other accounts were pensions, I was actually able to go short in the stock market. I was also long bonds. Both positions did very well, and his account went up dramatically.

As a last resort, I went to see this client to ask him if he might be interested in funding us in exchange for a percentage of the company. At the time, it probably looked like one of the dumbest purchases anybody could ever make. Here was a firm with a $40,000 negative net worth and a built-in deficit of $110,000 per year, run by a twenty-eight-year-old with only a one-year track record and no particular reputation. I sold him 25 percent of the company for $150,000, which I figured would be enough to keep us going for another twelve months.

One month later, the bull market began, and within about a year, our assets under management climbed to $40 million. I think 1983 was the first year I had a quarter in which I actually made more than my secretary. We had a bit of a setback during the mid-1983 to mid-1984 period, but the company continued to do well thereafter, particularly once the bull market took off in 1985.

Given the success of your own trading company, why did you leave to join Dreyfus as a fund manager?

In 1985 I met Howard Stein, who offered me a consulting agreement with Dreyfus. He eventually convinced me to officially join Dreyfus as a manager of a couple of their funds. They even tailored new Dreyfus funds around my particular style of investment. As part of the agreement, I was allowed to continue to manage the Duquesne Fund. In fact, I’m still managing Duquesne today.

What were your personal experiences preceding, during, and after the 1987 stock market crash?

The first half of the year was great because I was bullish on the market, and prices went straight up. In June I changed my stripes and actually went net short. The next two months were very rough because I was fighting the market, and prices were still going up.

What determined the timing of your shift from bullish to bearish?

It was a combination of a number of factors. Valuations had gotten extremely overdone: The dividend yield was down to 2.6 percent and the price/book value ratio was at an all-time high. Also, the Fed had been tightening for a period of time. Finally, my technical analysis showed that the breadth wasn’t there—that is, the market’s strength was primarily concentrated in the high capitalization stocks, with the broad spectrum of issues lagging well behind. This factor made the rally look like a blow-off.

How can you use valuation for timing? Hadn’t the market been overdone in terms of valuation for some time before you reversed from short to long?

I never use valuation to time the market. I use liquidity considerations and technical analysis for timing. Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction.

The catalyst being what?

The catalyst is liquidity, and hopefully my technical analysis will pick it up.

What was happening in terms of liquidity in 1987?

The Fed had been tightening since January 1987, and the dollar was tanking, which suggested that the Fed was going to tighten some more.

How much were you up during the first half of 1987 before you switched from long to short?

The results varied depending on the fund. I was managing five different hedge funds at the time, each using a different type of strategy. The funds were up roughly between 40 percent and 85 percent at the time I decided to switch to a bearish posture. Perhaps the strongest performer was the Dreyfus Strategic Aggressive Investing Fund, which was up about 40 percent during the second quarter (the first quarter of the fund’s operation). It had certainly been an excellent year up to that point.

Many managers will book their profits when they’re up a lot early in the year. 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. Since I was well ahead for the year, I felt that I could afford to fight the market for a while. I knew the bull market had to end, I just didn’t know when. Also, because of the market’s severe overvaluation, I thought that when the bull market did end, it was going to be dramatic.

Then I assume that you held on to your short position until the market actually topped a couple of months later.

That’s right. By October 16, 1987, the Dow had come down to near the 2,200 level, after having topped at over 2,700. I had more than recouped my earlier losses on the short position and was back on track with a very profitable year. That’s when I made one of the most tragic mistakes of my entire trading career.

The chart suggested that there was tremendous support near 2,200 based on a trading range that had been built up during most of 1986. I was sure that the market would hold at that level. I was also playing from a position of strength, because I had profits from my long positions earlier in the year, and I was now ahead on my short positions as well. I went from net short to a 130 percent long. [A percentage greater than 100 percent implies the use of leverage.]

When did you make this transition?

On Friday afternoon, October 16, 1987.

You reversed from short to a leveraged long position on the day before the crash? You’re kidding!

That’s right, and there was plenty of liquidity for me to switch my position on that day.

I’m not surprised, but I’m somewhat puzzled. 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.

When did you realize that you were wrong?

That Friday afternoon after the close, I happened to speak to Soros. He said that he had a study done by Paul Tudor Jones that he wanted to show me. I went over to his office, and he pulled out this analysis that Paul had done about a month or two earlier. The study demonstrated the historical tendency for the stock market to accelerate on the downside whenever an upward-sloping parabolic curve had been broken—as had recently occurred. The analysis also illustrated the extremely close correlation in the price action between the 1987 stock market and the 1929 stock market, with the implicit conclusion that we were now at the brink of a collapse.

I was sick to my stomach when I went home that evening. I realized that I had blown it and that the market was about to crash.

Was it just the Paul Tudor Jones study that made you realize that you were wrong?

Actually, there’s a second important element to the story. In early August of that year, I had received a call from a woman who was about to leave for a vacation to France. She said, “My brother says that the market is getting out of hand. I have to go away for three weeks. Do you think the market will be all right until I get back?”

I tried to be reassuring, telling her, “The market will probably go down, but I don’t think it will happen that quickly. You can go on your vacation without worry.”

“Do you know who my brother is?” she asked.

“I have no idea,” I answered.

“He’s Jack Dreyfus,” she informed me.

As far as I knew, Dreyfus was busy running a medical foundation and hadn’t paid much attention to the market for the past fifteen or twenty years. The following week, Howard Stein brought a visitor to my office. “This is Jack Dreyfus,” he announced.

Dreyfus was wearing a cardigan sweater and was very polite in his conversation. “I would like to know about the S&P futures contract,” he said. “As you know, I haven’t looked at the market for twenty years. However, I’ve been very concerned about the conversations I’ve been hearing lately when I play bridge. Everyone seems to be bragging about all the money he’s making in the market. It reminds me of everything I read about the 1929 market.”

Dreyfus was looking for evidence of margin buying to confirm his conjecture that the market was poised for a 1929-type crash. The statistics on stocks didn’t reveal any abnormally high level of margin buying. However, he had read that people were using S&P futures to take long positions in the stock market at 10 percent margin. His hypothesis was that the margin-type buying activity was now going into futures. To check out this theory, he wanted me to do a study to see if there had been any unusually heavy speculative buying of S&P futures.