How Stan Druckenmiller missed market top by an hour and lost half his fund

For indeed, the investor’s chief problem – and even his worst enemy – is likely to be himself.

Benjamin Graham

This is a rather spectacular story. It is 20 years old but it is as relevant today as it ever was for it sheds light on one of the key problems in investment speculation: human psychology.

Regardless of how diligently you study markets, large-scale price events are simply unpredictable. For example, many market analysts have been predicting high inflation already in 2010. Over the next ten years however, inflation has remained tame. In 2016, the bulk of so-called “smart money” investors were strongly bearish on U.S. equities, only to see the S&P500 advance more than 50% over the next four years. And who could forget the 1990s Nasdaq boom? Already in 1996 many observers thought that the markets succumbed to a frenzy of irrational exuberance, but the stocks continued rolling higher for another three years. During the last five months of that bubble, the Nasdaq added fully 110% before finally peaking in the early 2000.

As I elaborated at the following link, such large-scale price events represent the greatest risk, as well as the greatest opportunity in investment trading. However, even the smartest of ‘smart money’ can’t predict them, which can turn very destructive for speculators. Take the ‘market wizard’ Stanley Druckenmiller. During the Dot-Com boom, he understood that the technology stocks were dramatically overvalued and he accumulated a large short position in many internet ventures well ahead of the market crash. But as stock prices advanced over the following months, his positions generated large losses.

At the same time, Druckenmiller’s younger peers had piled into the tech stocks with reckless abandon and for a while the markets rewarded them with spectacular returns, each month reaffirming the prevailing groupthink that, “this time it’s different.” Eventually, Druckenmiller could take no more of the humiliation: he closed out his short positions and went long the tech stocks, literally hours before the Nasdaq peaked. What followed was an epic bust during which 75% of Druckenmiller’s original shorts went bankrupt while the rest sustained losses of between 90% and 99%. But instead of having an absolutely blow-out year, Druckenmiller lost half of the $6 billion fund in only a few weeks’ time. Here’s the story of the way captain Druckenmiller navigated that market storm.

How the Nasdaq crushed the market wizard Stanley Druckenmiller

At a 2015 event^[1] where he gave a keynote speech, Druckenmiller was asked what he thought the biggest mistake of his career was and what he’d learned from it. His remarks are highly illuminating:

“… in 1999 after Yahoo and America Online had already gone up like tenfold, I got the bright idea at Soros to short internet stocks. And I put 200 million in them in about February and by mid-March the 200 million short I had lost $600 million on, gotten completely beat up and was down like 15 percent on the year. And I was very proud of the fact that I never had a down year, and I thought well, I’m finished.

So the next thing that happens is I can’t remember whether I went to Silicon Valley or I talked to some 22-year old with Asperger’s. But whoever it was, they convinced me about this new tech boom that was going to take place. So I went and hired a couple of gun slingers because we only knew about IBM and Hewlett-Packard. I needed Veritas and Verisign. … So, we hired this guy and we end up on the year – we had been down 15 and we ended up like 35 percent on the year. And the Nasdaq’s gone up 400 percent.

So I’ll never forget it. January of 2000 I go into Soros’s office and I say I’m selling all the tech stocks, selling everything. This is crazy. [unintelligible] This is nuts. Just kind of as I explained earlier, we’re going to step aside, wait for the next fat pitch. I didn’t fire the two gun slingers. They didn’t have enough money to really hurt the fund, but they started making 3 percent a day and I’m out. It is driving me nuts. I mean their little account is like up 50 percent on the year.

I think Quantum was up seven. It’s just sitting there. So like around March I could feel it coming. I just – I had to play. I couldn’t help myself. And three times during the same week I pick up a – don’t do it. Don’t do it. Anyway, I pick up the phone finally. I think I missed the top by an hour. I bought $6 billion worth of tech stocks and in six weeks I had left Soros and I had lost $3 billion in that one play.

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.”

I don’t think many people would call Stanley Druckenmiller stupid. For years he had delivered remarkable investment performance and built up a personal fortune of over $4 billion. But the markets can make very smart people look stupid – and vice versa. Day after day, Stanley Druckenmiller watched technology stocks skyrocket and his younger and much less experienced colleagues make huge returns while his fund tread water. What they were doing seemed to be working, and what he was doing wasn’t. Day after day the markets were telling him that his “gunslingers” were right and he was wrong; that they were smart and he stupid. Eventually he abandoned his discipline and joined the herd even though in his rational judgment he knew he was doing the wrong thing. “I was just an emotional basket case and I couldn’t help myself,” says Druckenmiller.

Every investor should ponder those words, because what happened to Stanley Druckenmiller can happen to anyone.

Trend following can protect you from your own convictions

The one group of market participants who don’t run the risk of being their own worst enemy are the trend followers. Rather than trying to outsmart the markets and guess what tomorrow might bring, trend followers simply sail with the prevailing trends. As a result, they tend to be on the right side of large-scale price moves, which are always the greatest source of investment returns. If you doubt this last statement, think about investing in things like Microsoft, Amazon, Google, Tesla or Uber… Whatever you thought of their valuations, business models, management, or their services – it is the price appreciation of their shares that generated the spectacular investment returns for their stock owners.

From today’s perspective, the future developments will fall between two extremes. With the stock prices at historical highs, we could see the bursting of the bubble followed by an extended bear market as happened in the aftermath of Japan’s 1980s bubble:

Alternatively, an inflationary future could see a continued growth of the equity bubble as we’ve seen in a number of countries with high rates of inflation:

Opinions differ. But a trend follower will avoid getting attached to either conviction. Instead, he’ll allow the observed reality to guide his decisions. As another of Schwagger’s market wizards, Paul Tudor Jones put it recently, “One thing I have learned over time is that the best thing to do is let market price action guide your decision-making. … Quite often, how the markets respond will be at odds with your priors…”

This is why my work as market analyst and the frustrations I encountered with it led me to embrace trend following as perhaps the best answer to the problem of uncertainty. As a result, in the mid-1990s my team and I created the I-System, probably the best trend following model ever built (see why at the link). Today I-System enables us to deliver daily TrendCompass reports covering over 200 financial and commodity markets as well as a variety of high quality turn-key portfolio solutions to help traders, investors and hedgers navigate the coming market turbulence profitably, with confidence and peace of mind.

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Notes:

[1] Armour, Timothy. “Stanley Druckenmiller Lost Tree Club 1-18-2015” Transcript, 12 Feb. 2015.