May 5, 2015


On January 18, 2015, arguably the best investor of our time spoke at a private dinner at the Lost Tree Club in North Palm Beach, Fl.  I have shared his thoughts in many of my previous commentaries and his name is Stanley Druckenmiller. 


A transcript of the discussion was recently posted on the Internet and it is a worthwhile piece to review.  I am going to use this commentary to highlight many of Druckenmiller’s thoughts that he shared. 


The discussion here will start with the introduction that was given before Druckenmiller began to speak, then highlight thoughts he shared on his investing career and finally shift to his perspective on the current environment.  The introduction will tee up why it is worthwhile to at least consider Druckenmiller’s perspective.  Remember, this is not a written letter but a rough transcript of the conversation at the Club.  Also, I am not going to include everything such as comments on side topics outside the investing world.


If you have wondered why I have spent so many of my commentaries over the last few years focused on our Federal Reserve as well as the rest of the central banks around the world, Druckenmiller helps to explain why monetary policy, especially when it looks like they are making a mistake, is so important to the markets.  This discussion is worthwhile to read, read again and again.  Think hard about the implications and make sure you are positioned accordingly.  And remember the saying, “Things take longer to happen than you think they will, but when it happens it goes faster than you thought it would.”


First, here is the introduction…


“And we’ve had these wonderful speakers [referring to past speakers at the Lost Tree Club], and tonight there’s no exception.  I think tonight is going to be fascinating and thought-provoking as we hear maybe a different slant on investing.  We all have savings.  We all want to enhance the value of those savings.  Thirty to 35 years ago, basically it was just a ratio of stocks versus bonds and that would depend on the stock broker.  By 1980 when Stan first started in the business, you had different types of strategies.  You had the hedge fund strategies that were just coming on, you had the LBOs, you had private equity.  You had all the different strategies coming on.  Then you had Volcker battling against inflation.  Won that.  Then you had the Reagan supply-side.  So that created tremendous tailwinds for investing.  Then you had the technology revolution, you had the frontier markets, your emerging markets, all these things; the current fluctuation driven by a lot of the central banks being on steroids, if you would.”


“All of these developments created a chance for massive gains and massive losses.  And with increased complexity of all of this we all need help in investing.  We need money managers, but I think you need more than that.  You need prescient practitioners, and we’re going to talk about that a little bit and rightfully so because $1,000 invested 30 years ago in the S&P – S&P compounded about 11 %, a little over 11.3%, something like that.  Your $1,000 would be $27,000 before taxes today, 25 up years and 5 down years, which is also important.”


“Probably the poster child of investors, Warren Buffett, in the last 30 years has compounded just under 20%.  A thousand dollars 30 years ago would be worth $177,000 today, 24 up years and 6 down years of which 3 of the 6 were more than 20%, and that’s going to be interesting when we get to that.”


“So, our speaker tonight if you invested $1,000, 30 years ago, today it would be $2.6 million before taxes.  Thirty years, no losses.  Brian and I were talking last night, it’s hard to do anything for 30 years and not have one losing year.  That’s a phenomenal thing.”


Now, the discussion shifts over to Druckenmiller speaking about his past investment experience…


“I thought I would spend a moment just reflecting on why I believe my record was what it was, and maybe you can draw something from that.  But the first thing I’d say very clearly, I’m no genius.  I was not in the top 10 % of my high school class.  My SATs were so mediocre I went to Bowdoin because it was the only good school that didn’t require SATs, and it turned out to be a very fortunate event for me.”


“But I’d list a number of reasons why I think I had the record I did because maybe you can draw on it in some of your own investing or also maybe in picking a money manager.  Number one, I had an incredible passion, and still do, for the business.  The thought that every event in the world affects some security price somewhere I just found incredibly intellectually [blank in the transcript] to try and figure out what the next puzzle was and what was going to move what.”


“The second thing I would say is I had two great mentors.  One I stumbled upon and one I sought out.  If you’re early on in your career and they give you a choice between a great mentor or higher pay, take the mentor every time.  It’s not even close.”


“The third thing I’d say is I developed partly through dumb luck – I’ll get into that – a very unique risk management system.  The first thing I heard when I got into 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 anywhere.”


“And if you look at all the great investors that are as different as Warren Buffett, Carl Icahn, Ken Langone, they tend to make very, very concentrated bets.  They see something, they bet on 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.  And if you look at what excites you and then you look down the road, your record on those particular transactions is far superior to everything else; but 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.”


“Ken Langone knows my first mentor very well.  [Drelles]  He’s not a well-known guy, but he was absolutely brilliant, and I would say a bit of a maverick.  He taught me two things.  A, never, ever invest in the present.  It doesn’t matter what a company’s earning, what they have earned.  He taught me that you have to visualize the situation 18 months from now, and whatever that is, that’s where the price will be, not where it is today.  If you invest in the present, you’re going to get run over.”


“The other thing he taught me is earnings don’t move the overall market; it’s the Federal Reserve Board.  And whatever I do, focus on the central banks and focus on the movement of liquidity; that most people in the market are looking for earnings and conventional measures.  It’s liquidity that moves markets. “


The first job Druckenmiller had as an investor was with this mentor at Pittsburgh National bank, who put him in as director of research at the age of 25, and his mentor left 3 months later.  Right after his mentor left, the Shah of Iran goes under.  “So, oil looked like it was going to go up 300%.  I didn’t know anything about portfolio managers.  So, I go well, this is easy.  Let’s put 70% of our money in oil stocks and let’s put 30% in defense stocks and let’s sell all our bonds.  The portfolio managers that were competing with me for the top job, they, of course, thought it was crazy.  I would have thought it was crazy too if I’d have had any experience, but the list I proposed went up 100%.  The S&P was flat.  And then at 26 years old they made me chief investment officer of the whole place.  So, the reason I say there was a lot of luck involved is because, as Drelles predicted, it was my youth and it was my inexperience, and I was ready to charge.”


“So, the next thing that happened when I started Duquesne [his investment firm], Ronald Reagan had become President, and we had a radical man named Paul Volcker running the Federal Reserve.  And inflation was 12%.  The whole world thought it was going to go through the roof, and Paul Volcker had other ideas.  And he raised interest rates to 18% on the short end, and I could see that there was no way this man was going to let inflation go.  So, I had just started Duquesne.  I had a small amount of new capital.  I took 50% of the capital and put it into 30-year treasury bonds yielding 14 %, and I owned nothing else.  Sort of like the oil and defense story, but now we’re on a different gig.  And sure enough, the bonds went up despite a bear market in equities.  Right out of the chute I was able to be up 40%.  And more importantly, it sort of shaped my philosophy again of you don’t need like 15 stocks or this currency or that.  If you see it, you got to go for it because that’s a better bet than 90% of the other stuff you would add onto it.”


“So, after that happened, my second mentor was George Soros, and unlike Speros Drelles, I imagine most of you have heard of George Soros.  And, had I known Soros when I made the bond bet, I probably would have made a lot more money because I wouldn’t have put 50% in the bonds, I probably would have put about 150% in the bonds.  So, how did I meet Soros?  By the early to mid-‘80s commodities were having big moves, bonds were having big moves, and I was developing a philosophy that if I can look at all these different buckets and I’m going to make concentrated bets, I’d rather have a menu of assets to choose from to make my big bets and particularly since a lot of these assets go up when equities go down, and that’s how it was moving.”


“And then I read The Alchemy of Finance because I’d heard about this guy, Soros.  And when I read The Alchemy of Finance, I understood very quickly that he was already employing an advanced version of the philosophy I was developing in my fund.  So, when I went over to work for George, my idea was I was going to get my PhD in macro portfolio management and then leave in a couple of years or get fired like the nine predecessors had.  But it’s funny because when I went over there, I thought what I would learn would be like what makes the yen go up, what makes the deutsche mark move, what makes this, and to my really big surprise, I was as proficient as he was, maybe more so, in predicting trends.”


“That’s not what I learned from George Soros, but I learned something incredibly valuable, and that is when you see it, to bet big.  So what I had told you was already evolving, he totally cemented.  For those who follow baseball, I had a higher batting average; Soros had a much bigger slugging percentage.  When I took over Quantum [Soros’ fund], I was running Quantum and Duquesne [his own fund].  He [Soros] was running his personal account, which was about the size of an institution back then, by the way, and he was focusing 90% of his time on philanthropy and not really working day to day.  In fact a lot of the time he wasn’t even around.”


“And I’d say 90% of the ideas he was using came from me; and it was very insightful, and I’m a competitive person, frankly embarrassing, that in his personal account working about 10% of the time he continued to beat Duquesne and Quantum while I was managing the money.  And again it’s because he was taking my ideas and he just had more guts.  He was betting more money with my ideas than I was.”


“Probably nothing explains our relationship and what I’ve learned from him more than the British Pound.  So, in 1992, in August of that year my housing analyst in Britain called me up and basically said that Britain looked like they were going into a recession because the interest rate increases they were experiencing were causing a downturn in housing.”  Germany, on the other hand was experiencing growth and they were raising rates due to their history of worrying about inflation.  “That all sounds normal except the Deutsche Mark and the British Pound were linked.  And you cannot have two currencies where one economic outlook is going like this way and the other outlook going that way.  So, in August of ’92 there was 7 billion in Quantum.  I put a billion and a half, short the British Pound based on the thesis I just gave you.”


“So, fast-forward to September, next month.  I wake up one morning and the head of the Bundesbank, Helmut Schlesinger, has given an editorial in the Financial Times, and I’ll skip all the flowers.  It basically said the British Pound is crap and we don’t want to be united with this currency.  So, I thought well, this is my opportunity.  So, I decided I’m going to bet like Soros bets on the British pound against the Deutsche Mark.”


“It just so happens he’s in the office.  He’s usually in Eastern Europe at this time doing his thing.  So, I go in at 4:00 and I said, ‘George, I’m going to sell $5.5 billion worth of the British Pound tonight and buy Deutsche Marks.  Here’s why I’m doing it; that means we’ll have 100% of the fund in this one trade.’  And as I’m talking, he starts wincing like what is wrong with this kid, and I think he’s about to blow away my thesis and he says, ‘That is the most ridiculous use of money management I ever heard.  What you described is an incredible one-way bet.  We should have 200% of our net worth in this trade, not 100%.  Do you know how often something like this comes around?  Like one out of 20 years.  What is wrong with you?’  So, we started shorting the British Pound that night.  We didn’t get the whole $15 billion on, but we got enough that I’m sure some people in the room have read about it in the financial press.”


“So, that’s probably enough old war stories tonight.  I love telling old war stories because I like to reminisce when I was a money manager and doing better returns than I have since I retired.  Let’s try and move to the present here a little bit.  So, I told you that one of the things I learned from Drelles was to focus on central banks.  And Sam was kind enough to point out some very good returns we had over the years.”


Here is where Druckenmiller shifts to address recent events and what is going on now…


“One of the things I would say is about 80% of the big, big money we made was in bear markets and equities because crazy things were going on in response to what I would call central bank mistakes during that 30-year period.  And probably in my mind the poster child for a central bank mistake was actually the U.S. Federal Reserve in 2003 and 2004.  I recall very vividly at the end of the fourth quarter of 2003 calling my staff in because interest rates, fed funds were one percent.  The nominal growth in the U.S. that quarter had been 9%.  All our economic charts were going through the roof, and not only did they have rates at one percent, they had this considerable period – sound familiar? – language that they were going to be there for a considerable time period.”


“So, I said I want you guys to try and block out where fed funds are and just consider this economic data and let’s play a game.  We’ve all come down from Mars.  Where do you think fed funds would be if you just saw this data and didn’t know where they were?  And I’d say of the seven people, the lowest guess was 3% and the highest was 6%.  So, we had great conviction that the Federal Reserve was making a mistake with way too loose monetary policy.  We didn’t know how it was going to manifest itself, but we were on alert that this is going to end very badly.”


“Sure enough, about a year and a half later an analyst from Bear Stearns came in and showed me some subprime situations, the whole housing thing, and we were able to figure out by mid-’05 that this thing was going to end in a spectacular housing bust, which had been engineered – or not engineered but engendered by the Federal Reserve’s too-loose monetary policy and end in a deflationary event.  And we were lucky enough that it turned out to be correct.  My returns weren’t very good in ’06 because I was a little early, but ’07 and ’08 were – they were a lot of fun.”


“So, that’s why if you look at today, I’m experiencing a very strong sense of déjà vu.  Let’s just play the game I played with my analysts back in 2003, 2004 and go through a series of charts.  So, this is the U.S. households’ net worth per household.  And it’s textbook.  You see the big drop in the financial crisis.  It’s textbook when you have consumer balance sheets torn to pieces by a financial crisis to use super loose monetary policy to rebuild those balance sheets, which the Federal Reserve did beautifully.”


“What is interesting though is if you look forward to 2011, we had already exceeded the ’07 levels, which I think a lot of people would agree was already an overheated period, and since then we’ve gone straight up for two more years, and household net worth is certainly in very, very good shape.”


“Here’s employment.  As you can see after another big problem after the financial crisis, the employment market has largely healed, and we’re down at 5.6% on the unemployment rate.  Here’s industrial production.  Again, big drop after ’07.  Look at this thing.  It’s screaming.  Here’s retail sales.  Again you see the damage, but you see where we are now.  You’re right on a 60-year uptrend, which is actually very good.”


“And then I’m sure for those of you who are unfortunate enough to watch CNBC and read other financial statements, you’ll know that the Fed is absolutely obsessed with Japan.  They’ve been talking about this Japan analogy for 10 to15 years now or certainly since Bernanke took over.  And let me just show you something.  This is the core CPI in the U.S.  I’m sure you’ve heard the word ‘deflation’ more than you’d like to hear it in the last three or four years.  We’ve never had deflation.  Our CPI has gone up 40% over this time with not one period of deflation.  And at the bottom you see Japan, which is down 15%.  I did think there was a case, a viable case in ’09, ’10 that we may follow Japan.  But you know what, I’ve thought a lot of things when I’m managing money with great, great conviction, and a lot of times I’m wrong.  And when you’re betting the ranch and the circumstances change, you have to change, and that’s how I’ve always managed money.  But the Fed’s thesis to me has been proved dead wrong about three or four years ago, which is okay, but there was no pivot.”


“So, my point is this, if I was giving you a quiz and you looked at these five charts and you hear all this talk about a deflation and depression and how horrible things are, let me just say this, the Federal Reserve was founded in 1913.  This is the first time in 102 years, A, the central bank bought bonds and, B, that we’ve had zero interest rates and we’ve had them for five or six years.  So, do you think this is the worst economic period looking at these numbers we’ve been in in the last 102 years?  To me it’s incredible.”


“Now, the Fed will say well, you know, if we didn’t have rates down here and we didn’t increase our balance sheet, the economy probably wouldn’t have done as well as it’s done in the last year or two.  You know what, I think that’s fair, it probably wouldn’t have.  It also wouldn’t have done as well as it did in 2004 and 2005.  But you can’t measure what’s happening just in the present in the near-term.  You got to look at the long-term.”


“And to me it’s quite clear that it was the Federal Reserve policy.  I don’t know whether you remember, they kept coming up with this term back at the time, they wanted an insurance policy.  This we got to ensure this economic recovery keeps going.  The only thing they ensured in my mind was the financial crisis.  So, to me you’re getting the same language again out of policymakers.  On a risk-reward basis why not let this thing get a little hot?  You know, we got to ensure that it gets out.  But the problem with this is when you have zero rates for so long, the marginal benefits you get through consumption greatly diminish, but there’s one thing that doesn’t diminish, which is unintended consequences.”


“People like me, others, when they get zero money – and I know a lot of people in this room are probably experiencing this, you are forced into other assets and risk assets and behavior that you really don’t want to do, and it’s not those concentrated bets kind of stuff I mentioned earlier.  It’s like gees, these zero rates are killing me.  I got to do this.  And the problem is the longer rates stay at zero and the longer assets respond to that, the more egregious behavior comes up.”


“Now, people will say well the PE is not that high.  Where’s the beef?  Again, I feel more like it was in ’04 where every bone in my body said this is a bad risk reward, but I can’t figure out how it’s going to end.  I just know it’s going to end badly, and a year and a half later we figure out it was housing and subprime.  I feel the same way now.  There are early signs again.  If you look at IPOs 80% of them are unprofitable when they come.  The only other time we’ve been at 80% or higher was in 1999.”


“The other thing I would look at is credit.  There are some really weird things going on in the credit market that maybe Kenny and I can talk about later.  But there are already early signs starting to emerge.  And to me if I had a message out here, I know you’re frustrated about zero rates, I know that it’s so tempting to go ahead and make investments and it looks good for today, but when this thing ends, because we’ve had speculation, we’ve had money building up for four to six years in terms of a risk pattern, I think it could end very badly.”


That concludes his speech and now here is some of the question and answer session…


Question:  You mentioned in your talk that there are already early signs of excesses due to over-easy monetary policy.  What are some of the signs you see?


Druckenmiller:  “Okay.  I mentioned credit.  Let’s talk about that for a minute.  In 2006 and 2007, which I think most of us would agree was not a down period in terms of speculation; corporations issued $700 billion in debt over that two-year period.  In 2013 and 2014, they’ve already issued $1.1 trillion in debt, 50% more than they did in the ’06, ’07 period over the same time period.  But more disturbing to me if you look at the debt that is being issued, back in ’06, ’07, 28% of that debt was B rated.  Today, 71% of the debt that’s been issued in the last two years is B rated.  So, not only have we issued a lot more debt, we’re doing so at much less standards.”


“Another way to look at it is if those in the audience who know what covenant-light loans are, which are loans without a lot of stuff tied around you, back in ’06, ’07 less than 20% of the debt was issued covenant-light.  Now that number is over 60%.  So, that’s one sign.  The other sign I would say is in corporate behavior, just behavior itself.  So, let’s look at the current earnings of corporate America.  Last year they earned $1.1 trillion with $1.4 trillion in depreciation.  Now, that’s about $2.5 trillion in operating cash flow.  They spent $1.7 trillion on business and capital equipment and another $700 billion on dividends.  So, virtually all of their operating cash flow has gone to business spending and dividends, which is okay.  I’m onboard with that.”


“But then they increase their debt by $600 billion.  How did that happen if they didn’t have negative cash flow?  Because they went out and bought $567 billion worth of stock back with debt, by issuing debt.  So, what’s happening is their book value is staying virtually the same, but their debt is going like this.  From 1987 when Greenspan took over for Volcker, our economy went from 150% debt to GDP to 390% as we had these easy money polices moving people more and more out the risk curve.  Interestingly, in the financial crisis that number went down from about 390% to 365%.  But now because of corporate behavior, government behavior, and everything else, those ratios are starting to go back up again.”


Then, he gets a question about inflation and his response is, “So, the Fed keeps talking about deflation, but there is nothing more deflationary than creating a phony asset bubble, having a bunch of investors plow into it and then having it pop.  That is deflationary.”


Another question asked him about mistakes he has made.  A summary of his answer was that he resisted the technology bubble for a long while and then right near the peak, he succumbed to the pressure of missing out and bought a lot of tech stocks right at the top.  He said regarding this mistake, “You asked me what I learned.  I didn’t learn anything.  I already knew that I wasn’t supposed to do that.  I was just an emotional basket case and couldn’t help myself.  So, maybe I learned not to do it again, but I already knew that.”


The next question asked about the regulators and how they are penalizing the banks.  He answered, “There were some very, very bad actors in ’06 and ’07 in the banking industries.  But the point I was making earlier is there was a great enabler, and that was the Federal Reserve pushing people out the risk curve.  And what I just can’t understand for the life of me, we’ve don Dodd-Frank, we got 5,000 people watch Jamie Dimon when he goes to the bathroom.  I mean all this stuff going on to supposedly prevent the next financial crisis.  And if you look at the real root cause behind the financial crisis, we’re doubling down.  Our monetary policy is so much more reckless and so much more aggressively pushing the people in this room and everybody else out the risk curve that we’re doubling down on the same policy that really put us there and enabled those bad actors to do what they do.  Now, no matter what you want to say about them, if we had had 5 or 6% interest rates, it would have never happened because they couldn’t have gotten the money to do it.”


The last question was whether or not there is any way possible you think that we could have a soft landing from all the excesses we’ve had in the last 10 or 15 years.  His answer was, “Anything’s possible.  I sure hope so.  And I haven’t committed [as of January when he gave his speech].  I’m not net short equities.  I mean the stock market right now as a percentage of GDP is higher than – with the exception of nine months around 1999 – it’s the highest it’s been in the last hundred years of any other period except for those nine months.  But you know what, when you look at the monetary policy we’re running, it should be – it should be about where it is.  This is crazy stuff we’re doing.  So, I would say you have to be on alert to that ending badly.  Is it for sure going to end badly?  Not necessarily.  I don’t quite know how we get out of this, but it’s possible.”


No need to comment this month.  You have read my thoughts on these topics before and I will share plenty more in the months ahead, but for now just think through the thoughts of “Druck.”



Joseph R. Gregory, Jr.





 Past results are not indicative of future results.  Joseph Gregory is President of Heritage Capital Partners, Inc., a registered investment advisor.  All materials presented herein are believed to be reliable but we cannot attest to its accuracy.  All material represents the opinions of Joseph Gregory.  Investment opinions or recommendations may change and readers are urged to check with their financial advisor before making any investment decisions.  Opinions expressed in these commentaries may change without prior notice.  Joseph Gregory and/or clients of Heritage Capital Partners, Inc. may or may not have investment positions that are in or aligned with any opinions mentioned in these commentaries.  There is risk of loss as well as opportunity for gain when investing in the financial markets.  Investment opinions or positions mentioned in these commentaries are not suitable for all readers and therefore, readers are urged once again to check with their financial advisors before making any investment decisions.