The New Market Wizards: Conversations with America's Top Traders (27 page)

Since we didn’t have the data readily available, it took us a while to complete the study. Ironically, we finished the analysis on Friday afternoon, October 16, 1987. Basically, the data showed that speculators had been consistently short until July 1987 and after that point had switched to an increasingly heavy long position.

I went to see Jack Dreyfus on Saturday, October 17, to show him the results of the analysis. Remember, he had expressed all his concerns about the market in August. At this point, I was already very upset because Soros had shown me Paul Tudor Jones’s study.

Dreyfus looked at my study and said, “I guess we’re a bit too late to capitalize on my fears.” That was the clincher. I was absolutely convinced that I was on the wrong side of the market. I decided that if the market opened above the support level on Monday morning, which was about 30 Dow points lower, and didn’t immediately rally, I would sell my entire position. As it turned out, the market opened over 200 points lower. I knew I had to get out. Fortunately, there was a brief bounce shortly after the opening, and I was able to sell my entire long position and actually go net short.

That same afternoon, five minutes to four, Dreyfus came by. He said, “Forgive me for not telling you before, but I had already sold S&P futures to hedge my exposure in the stock market.”

“How much did you sell?” I asked.

“Enough,” he answered.

“When did you go short?” I asked.

“Oh, about two months ago.” In other words, he had gone short at exactly the top, right around the time I had told his sister not to worry about an imminent top in the stock market. He asked, “Do you think I should cover my short position here?”

At that point, even though the Dow had already fallen 500 points to near 1,700, the futures were trading at a level that was equivalent to a Dow of 1,300. I said, “Jack, you have to cover the position here. The S&P futures are trading at a 4,500-point discount based on the Dow!”

He looked at me and asked, “What’s a discount?”

So did he cover his position at that point?

He sure did—right at the absolute low.

Getting back to your career path, why did you leave Dreyfus?

I felt that I was managing too many funds (seven at the time I left). In addition to the actual management, each fund also required speaking engagements and other activities. For example, each fund held four board meetings per year.

How could you possibly find the time to do all that?

I couldn’t; that’s why I left. During this entire time period, I had been talking to Soros on an ongoing basis. The more I talked to him, the more I began to realize that everything people had told me about him was wrong.

What had they told you?

There were all these stories about turnover at the firm. George had a reputation for paying people well but then firing them. Whenever I mentioned that Soros had tried to hire me, my mentors in the business adamantly advised me not to go.

Soros had actually started referring to me as his “successor” before I ever joined the firm. When I went to Soros’s home to be interviewed, his son informed me that I was his tenth “successor.” None of the others had lasted too long. He thought it was hysterical. And when I arrived at Soros’s office the next day, the staff all referred to me as “the successor.” They also thought it was very funny.

Did you consider simply going back and managing your Duquesne Fund full-time after you left Dreyfus?

That was certainly an option. In fact, Duquesne’s assets under management had grown tremendously without any marketing at all simply because of all the publicity I had received from the strong performance of the Dreyfus funds.

Why didn’t you go that route?

Quite simply, because George Soros had become my idol. He seemed to be about twenty years ahead of me in implementing the trading philosophy I had adopted: holding a core group of stocks long and a core group of stocks short and then using leverage to trade S&P futures, bonds, and currencies. I had learned a tremendous amount just in my conversations with Soros. I thought it was a no-lose situation. The worst thing that could happen was that I would join Soros and he would fire me in a year—in which case I would have received the last chapter of my education and still have had the option of managing Duquesne. In the best case, it would all work out.

Did your relationship with Soros change once you started working for him?

The first six months of the relationship were fairly rocky. While we had similar trading philosophies, our strategies never meshed. When I started out, he was going to be the coach—and he was an aggressive coach. In my opinion, George Soros is the greatest investor that ever lived. But even being coached by the world’s greatest investor is a hindrance rather than a help if he’s engaging you actively enough to break your trading rhythm. You just can’t have two cooks in the kitchen; it doesn’t work. Part of it was my fault because he would make recommendations and I would be intimidated. After all, how do you disagree with a man with a track record like his?

Events came to a head in August 1989 when Soros sold out a bond position that I had put on. He had never done that before. To make matters worse, I really had a strong conviction on the trade. Needless to say, I was fairly upset. At that point, we had our first let-it-all-out discussion.

Basically, Soros decided that he was going to stay out of my hair for six months. Frankly, I wasn’t too optimistic about the arrangement because I thought that he had been trying to do that all along but was simply incapable of it. The situation was saved, however, by events heating up in Eastern Europe in late 1989. As you may know, transforming Eastern Europe and the Soviet Union from communist to capitalist systems has been Soros’s main endeavor in recent years. He has set up foundations in eleven countries to help achieve this goal. With George off in Eastern Europe, he couldn’t meddle even if he wanted to.

Everything started to come together at that time. Not only was I trading on my own without any interference, but that same Eastern European situation led to my first truly major trade for Soros’s Quantum Fund. I never had more conviction about any trade than I did about the long side of the Deutsche mark when the Berlin Wall came down. One of the reasons I was so bullish on the Deutsche mark was a radical currency theory proposed by George Soros in his book,
The Alchemy of Finance.
His theory was that if a huge deficit were accompanied by an expansionary fiscal policy and tight monetary policy, the country’s currency would actually rise. The dollar provided a perfect test case in the 1981–84 period. At the time, the general consensus was that the dollar would decline because of the huge budget deficit. However, because money was attracted into the country by a tight monetary policy, the dollar actually went sharply higher.

When the Berlin Wall came down, it was one of those situations that I could see as clear as day. West Germany was about to run up a huge budget deficit to finance the rebuilding of East Germany. At the same time, the Bundesbank was not going to tolerate any inflation. I went headlong into the Deutsche mark. It turned out to be a terrific trade.

How large a position did you put on?

About $2 billion.

Did you have any difficulty putting on a position that size?

No, I did it over a few days’ time. Also, putting on the position was made easier by the generally bearish sentiment at the time. The Deutsche mark actually fell during the first two days after the wall came down because people thought that the outlook for a growing deficit would be negative for the currency.

Any other major trades come to mind? I’m particularly interested in your reasoning for putting on a trade.

In late 1989 I became extremely bearish on the Japanese stock market for a variety of reasons. First, on a multiyear chart, the Nikkei index had reached a point of overextension, which in all previous instances had led to sell-offs or, in the worst case, a sideways consolidation. Second, the market appeared to be in a huge speculative blow-off phase. Finally, and most important—three times as important as everything I just said—the Bank of Japan had started to dramatically tighten monetary policy. Here’s what the Japanese bond market was doing at the same time. [Druckenmiller shows me a chart depicting that at the same time the Nikkei index was soaring to record highs, the Japanese bond market was plummeting.] Shorting the Japanese stock market at that time was just about the best risk/reward trade I had ever seen.

How did you fare at the start of the air war against Iraq when the U.S. stock market abruptly took off on the upside and never looked back? Were you short because the market had been in a primary downtrend before that point? If so, how did you handle the situation?

I came into 1991 with positions that couldn’t have been more poorly suited to the market price moves that unfolded in the ensuing months. I was short approximately $3 billion in the U.S. and Japanese stock markets, and I was also heavily short in the U.S. and world bond markets.

I started to change my market opinion during the first two weeks of 1991. On the way down, the pessimism regarding the U.S. stock market had become extreme. Everybody was talking about how the market would crater if the United States went to war against Iraq. Also, the breadth was not there. Even though the Dow Jones index had fallen to a new recent low, only about eighty of the seventeen hundred New York Stock Exchange stocks had made new lows.

By January 13, I had covered my short S&P futures position, but I was still short stock. On that day, I spoke to Paul Tudor Jones, who had just returned from participating in a roundtable discussion sponsored by Barron’s. He told me that eight out of the eight participating money managers had said they were holding their highest cash position in ten years. I’ll never forget that the S&P was near 310 and Paul said, “340 is a chip shot.” I was already turning bullish, but that conversation gave me an extra push in that direction. I was convinced that once the war started, the market had to go up, because everyone had already sold.

Why didn’t you wait until the war had actually started before you began buying?

Because everybody was waiting to buy after the war started. I thought it was necessary to start buying before the January 15 deadline set by the United States.

Had you switched completely from short to long before the huge rally on the morning following the start of the air war?

I had in the Duquesne Fund because it was more flexible. In Soros’s Quantum Fund, we had switched our S&P futures position from short to long, but we still had a huge short position in actual stocks. A large portion of this position was in the bank and real estate stocks, which were difficult to cover. We were fully long within a few days after the start of the war.

How did you fare after the smoke cleared?

As incredible as it may seem, we ended up having an up January after going into the month with a $3 billion short position in equities worldwide, a $3 billion short position in the dollar versus the Deutsche mark, and a large short position in U.S. and Japanese bonds—all of which proved to be the exact wrong positions to hold.

Why did you have such a large short position in the dollar versus the Deutsche mark?

This was the same position we had held on and off for over a year since the Berlin Wall had come down. The basic premise of the trade was that the Germans would adhere to a combined expansionary fiscal policy and tight monetary policy—a bullish combination for their currency.

What caused you to abandon that position?

There were two factors. First, the dollar had been supported by safe-haven buying during the U.S. war with Iraq. One morning, there was a news story that Hussein was going to capitulate before the start of the ground war. The dollar should have sold off sharply against the Deutsche mark on the news, but it declined only slightly. I smelled a rat. A second factor was the talk that Germany was going to raise taxes. In other words, they were going to reverse their expansionary fiscal policy, which would eliminate one of the primary reasons for our being long the Deutsche mark in the first place. In one morning, we bought about $3.5 billion against the Deutsche mark.

The United States is experiencing a protracted recession and extremely negative consumer sentiment [at the time of this interview, December 1991]. Do you have any thoughts about the long-term economic prospects for the country?

In my view, the 1980s were a ridiculous repeat of the 1920s. We had built up the debt-to-GNP ratio to unsustainable levels. I became more convinced about the seriousness of the problem with all the leveraged buyouts of the late 1980s, which made the overall debt situation get worse and worse. I have never believed that the current economic downturn was a recession; I have always viewed it as a debt liquidation, which some people call a depression. It’s not simply a matter of a two-quarter recession. It’s a problem where you build up years of debt, which will act as a depressant on the economy until it gets worked off over a long period of time. A debt liquidation tends to last for years.