"DRUCK"
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.