Stanley Druckenmiller  1:35  

First of all, a mix of financial repression and central bank intervention has made long term interest rates largely determined by government fiat. Bond buying by central bankers, commonly referred to as QE, has become so ingrained in current thinking that is now in the Fed’s conventional toolkit. A tool that was once reserved for depression or financial crisis is now used at the first inkling of the next recession. 

For those of us old enough to have seen the dangers of price controls, they lead to shortages, wasted resources, and disincentives to invest in what consumers want. They inevitably lead to an allocation of resources by political actors in another great affront to capitalism.

It is most surprising then that 40 years after wage and price controls were soundly rejected by every tech economic textbook and policymakers, today, we have settled to allow the most important price of all, long term interest rates, to be regularly distorted by public intervention. 

Exclusive this radical monetary policy has been the obsession with a fixed 2.0% inflation targeting a roll. The decimal point shows the absurdity of the exercise. Anything below 2.0% was a failure in reading deflation, the boogeyman of the 1930s to be avoided at all costs. This means that years after the great recession ended. 

The Fed has not only kept interest rates below inflation, but accumulated an unprecedented $4.5 trillion on their balance sheet by doing QE. Global central banks, in part to keep their currencies from appreciating these over abundant dollars, have followed with $10 trillion of their own. 

Now, the irony of this is over the last 700 years, inflation has averaged barely over 1% and interest rates have averaged just under 6%. We are then seeing an unprecedented ultra monetary, radical monetary expansion during a time of average inflation over the last number of centuries. 

Moreover, the three most pernicious deflationary periods of the past century did not start because inflation was too close to zero. They were preceded by asset bubbles. If I were trying to create a deflationary bust, I would do exactly what the world central bankers have been doing the last six years. 

I shudder to think that the malinvestment that occurred over this period. Corporate debt has soared, but most of it has been used for financial engineering. Who knows how many corporate zombies are out there because free money is keeping them alive? 

Individuals have *inaudible* ever increasing amounts of money into assets at ever increasing prices. It’s not only the private sector that’s getting the wrong message, but Congress as well.

I have no doubt we would have not gotten such a big increase in fiscal deficits, if policy had been normalized already. Of all the interventions by the not so invisible hand, not allowing the market to set the hurdle rate for investment is the one I see with the highest costs. The government should get out of the business of manipulating long term interest rates and cancelling market signals.

Stig Brodersen  5:06  

When Stanley Druckenmiller refers to long term interest rates here, he refers to bonds whose repayment is guaranteed by the government. It’s typically longer than 10 years. 

Now, long term interest rates are so important because it’s one of the key determinants of business investments. These long term interest rates can, if they’re low, encourage investments in new equipment. Whereas high interest rates discourage that, everything else being equal. It’s also one of the key determinants of economic growth. 

The key takeaway for me here really is that Stan Druckenmiller is saying that we should focus more on creating the best climate for growth and we should manage our asset bubbles. Really, if needed, we should allow for a minor recession in the short term, instead of taking the risk for the more likely scenario of a more severe crisis, if we keep putting all that liquidity into the system.

Preston Pysh 6:03  

Some really good thoughts there, Stig. In addition to what you’re explaining, I think it’s also important to talk about Stanley’s investment philosophy in general. Unlike Warren Buffett and many other value investors, Stan typically focuses heavily on central bankers. 

For instance, I’m going to read you a quote here, Stan said, “Earnings don’t move the overall market. It’s the Federal Reserve Board. Focus on the central banks and focus on the movement of liquidity. Most people in the markets are looking for earnings and conventional measures. It’s the liquidity that moves markets.”

So if you’re like me and it’s really hard to hear that quote because much of this Warren Buffett value investing style revolves around looking at the individual companies and ignoring the macro factors that are being impacted by central banks. 

However, it’s really important for people to hear how Stan thinks through his methodology since the inception of his Duquesne Capital Management Fund. His return has been 30% annually since 1981. That figure is absolutely absurd. 

I have another quote here that I want to read that kind of digs into the way he thinks about this central banking impact and how he starts with that narrative to understand where he’s at in cycles. 

The second quote goes like this, “The major thing that we look at is liquidity, meaning as a combination of an economic overview. Contrary to what a lot of the financial press have stated, looking at the great bull markets of this century, the best investments for stocks is a very dull, slow economy that the Federal Reserve is trying to get going.”

“Once an economy reaches a certain level of acceleration, the Fed is no longer with you. The Fed instead is trying to get the economy moving. The Fed instead of trying to get the economy moving, reverts to acting like the central bankers that they are and they start worrying about inflation and things get too hot. It tries to cool things off, shrinking liquidity, while at the same time, the corporations start having to build inventory, which again, takes money out of the financial assets.”

“Finally, if things get really heated, companies start engaging in capital spending. All three of these things tend to shrink the overall money available for investing in stocks and stock prices go down.”

The reason I’m reading all this is to really highlight the importance that he places on understanding this cycle and this dynamic. Really, [this is to highlight] the focus in the primary start by looking at what the central bankers do. 

When we play that sound clip and you kind of hear him talking about his views on what the central bank should be doing and the impacts, this is truly where Stan Druckenmiller starts his analysis. 

Let’s go ahead and dig into the next topic, which is really kind of a fascinating area to explore. In this question, Stan was asked the question about machines participating in the markets, specifically with respect to artificial intelligence.

Stan was asked about the lack of signals that he seems to be getting in the markets now compared to what he was seeing in the previous decades. This was how he responded.

Stanley Druckenmiller  9:16  

Someone said the other day, “You’ve been very critical of these algos.” 

I said, “Well not critical of the algos. They just made my life very inconvenient. It’s not that they’re doing anything wrong.” 

What I meant by that is a big part of my process is taking signals from markets. I’ve always believed markets are smarter than I am. They send out a message and then if I listen to them properly, no matter how powerful my thesis us, if they’re screaming something else, it’s telling me you’ve got to reevaluate and go back to an ancillary *inaudible.” However, you also have to be open-minded.

About six or seven years ago, a combination of central banks were canceling signals. Maybe more importantly, the algos came in with very, very sophisticated models based on historical events and stuff they’re picking up on the internet about who is shopping and on standard deviation away from price. They have come up with their own methodology of how to predict price movements and how to behave. 

Well, I grew up with someone fundamentally who likes security, and they buy it from somebody who fundamentally doesn’t like security. Somehow the invisible hand spit out a very good answer and it was predictive over time. I also learned that things would change and when the trend starts to go up, that’s what I’m supposed to pile in.

The algos machines trading, they tend to have different motivations, like they’re not nearly as momentum-oriented. Just when the trend may look like it’s going up, it may be just some algo whose got some standard deviation or something going on. It severely inhibited my ability to read the signals. 

My first mentor, *inaudible* back in Pittsburgh, he used to say 100 million Frenchmen can’t be wrong. That was his saying that the voice of the market was always correct and you need to listen to it. It was true. If a company was reporting great earnings and everybody loved it, and the stock just didn’t act well for three or four months, almost inevitably, something happened that you didn’t foresee six months down the road. 

I’ll never forget about how two or three years ago, Facebook had poured great earnings. The stock was like 122. Opened at 131 after hours. Then three days later, trading at 116. The analysts came in and they said, “*inaudible* nothing’s wrong. It’s great. It’s great.” 

I said, “No, kid, you’re wrong. Something’s going to come out. You just don’t know it yet. Something terrible in the next three or four months.” Anyway, a year later, the stock was like 220. So that didn’t mean anything. 

Conversely, I can remember so many examples when a company would report bad earnings. It goes down 5% on huge volume then closes up on the day. Almost invariably, three to six months later, that stock was higher. It doesn’t mean anything anymore other than some hedge fund. Maybe being a wise guy or somebody doing something. All the time I’ve seen that and a month later, the stock was actually lower. They certainly don’t work the way they used to. 

I still like price action versus news, but it used to be a very important part of my process. Now, it’s a much diminished part of my process.

Stig Brodersen  13:06  

It does feel good to hear that one of the greatest and have seen close to everything in the financial markets, he’s saying that the markets have changed. While there’s probably some truth to confirmation bias, you just want to be confirmed in what you already believe. I do think that this validates the thesis behind value investing even more. 

Now, I’m not so stubborn to say that you can’t make money off trading and reading price signals. However, I think you have to be very smart to do that. If not Druckenmiller smart, then very, very close to that, because you’re not engaging in this game with the tailwind from equities that’s going up. The companies you’re investing in are making a profit. 

Now, as a trader, you’re not only competing with professional traders, you’re also competing with computers. It’s just going to be harder and harder to compete in that space.

Preston Pysh 14:00  

Yeah, I really couldn’t agree more, Stig. When you hear a guy like Stan saying that AI bots are making life hard for him, it really makes you wonder how an amateur investor can get out there and outperform. 

If anything, it makes me second guess technical analysis and pattern analysis, especially in the short term basis, because so many of these automated systems, which make up 90% of the trading on the market, are relying on decades of data to assist in their decision making and the timing. 

All right, so as we move on to the next question and clip that we’re going to play here, this was recorded in December of 2018. These are Stan’s thoughts on the current market conditions.

Stanley Druckenmiller  14:42  

We did predict the last four recessions and our returns going into them and as they started, we’re always well above our average returns over time. Inside the stock market is one indicator. The second would be the yield curve. Again, amber, not red. But we’ve inverted from fives and twos, just slightly two years to 269, five years to 268, to 10 years to 285. 

There’s not only a big flattening going on. It’s very confusing both flattening because it’s not like we’re looking at higher rates to start with here and the Fed has told us that there are going to be three to four hikes next year after this hike. The market is just saying, “No, no, no.” 

Then the other thing we’ve looked at historically is that credit tends to lead the economy. There seems to be a confidence that this cycle, we don’t have the danger we had in the last cycle, because the bad stuff, our housing back then has not infected the banks. It was more done in the high yield loan market. 

To me, it’s true. It’s great that it’s not in the banks because that would probably be a systemic problem and financial crisis. However, the economy doesn’t really care whether credit is in the banks, or it’s in the investment community with high yield loans. 

In fact, I would argue that if you’re on the other side of it, you’d much rather work your loan out with a bank than you would with some hedge fund manager out there. So the fact that, I’m sure you read the article in The Financial Times yesterday, and the fact that credit is drying up to the extent that it is. There are also all sorts of warning signs there. 

I think the GECDS has gone from 50 basis points to 200 basis points, since September 1. IBM has gone from 30 to 80 high yield indexes, removing leveraged loans are down 3%. 

More importantly, because we’ve had eight years of free money, the kind of excesses are pushing people out and the yield curves that it has created. It’s just the time for caution that you want this bubble to unwind slowly now, because if you don’t… 

Let’s say these indicators turn red, you may have to do a lot more crazy monetary stuff. Actually, it’ll be more of a problem in terms of someone like me who eventually wants to normalize and wants to be leveraged. That’s the train I’ve been on. I understand but this is in an effort to let that bubble out slowly. 

Someone I believe used the term three or four years ago that this is a beautiful deleveraging taking place. I have no idea what he was talking about. How do you have a beautiful deleveraging with US debt going through the roof at the government level and corporate non-financial debt growing at the rate it has? 

What I’m asking for now is not a cut. Just to take stock of everything I’ve said and wait and see what happens. What I really like to think about my business, as you know, is risk reward. Let’s just talk about the risk reward here. 

Let’s suppose I’m completely wrong and three or four months from now, none of this stuff mattered. All the financial people are crazy and they were panicking because of some technical factor in the market. Let’s suppose the Fed did not hike tomorrow. What is the cost? 

I’m not sure what the cost is, but there’s got to be some cost to their credibility, two to three months down the road when they start hiking again. Not a big cost, in my opinion. 

Let’s suppose that these economic indicators, the stuff we’re looking at, the forward looking stuff, is right. Then we have big potential problems brewing and then they could be even bigger than we think because there’s stuff hiding out there. 

We don’t know about malinvestment. Think about the cost if they hiked tomorrow, and if they continue to shrink their balance sheet $50 billion a month, right when the ECB is not offsetting it. I mean, that cost to me is 5 to 10x.

Some really interesting comments that he brought up here, particularly there at the beginning, where he was saying, “I think we’re in a yellow status. I think we’re potentially in a topping process. I think the Fed needs to hold back on the tightening that they’re doing because we’re seeing the inversion in the bond yield curve.” 

Preston Pysh  19:43  

In general, I would say there’s just a lot of caution that he’s recommending here for investors and also for central bankers that are implementing their monetary policy. I also found his jab there at Ray Dalio interesting, where he said that he doesn’t understand how in the world this is a beautiful deleveraging, which I’m sure that’d be an interesting discussion to hear him and Ray hash that out. 

Just some real nuggets from a billionaire investor who gets 30% annual returns on where he kind of sees where we’re at entering 2019 in the stock market.

Stig Brodersen  20:20  

In this question, Stan Druckenmiller was asked, “When you had a down year, normally a fund manager would want to get aggressive and try to win it all back. What you do is to take lots of little bets that won’t hurt you. Why?” 

This was how Stan Druckenmiller responded.

Stanley Druckenmiller  20:37  

One of one of the lucky things was the way my industry prices you at the end of the year. You take a percentage of whatever profit was made for that year. So at the end of the year, psychologically and financially, you reset to zero last year. Profits are then yesterday’s news. 

I would always be a crazy person when I was down in a year but I know because I like to gamble that. In Las Vegas, 90% of the people that go there lose. The odds are only 33 to 32 against you and most of the big game. 

So how can 90% lose? It’s because they want to go home and brag that they won money. When they’re winning, and they’re hot, they’re very cautious. When they’re cold, and losing money, they’re betting big, completely irrational. This is important because I don’t think anyone has ever said it before. 

One of my most important jobs as a money manager was to understand whether I was hot or cold. Life goes in streaks, and like a hitter in baseball, sometimes money managers are seeing the ball, and sometimes they’re not. If you’re managing money, you must know whether you’re cold or hot. 

In my opinion, when you’re cold, you should be trying for months. You shouldn’t be swinging for the fences. You got to get back in a rhythm. So that’s pretty much how I put it. If I was down, I had not earned the right to play big. 

The little bets you’re talking about, were simply to tell me had I reestablished a rhythm and if I was starting to make hits again. The example I gave you of the Treasury Bed in 2000 is a total violation of that, which shows you how much conviction I had. 

This dominates my thinking, but if a once in a lifetime opportunity comes along,you can’t sit there and go, “Oh, well, I have not earned the right now.” I will also say that was after a four month break, my mind was fresh and clean. I will go to my grave believing if I hadn’t taken that sabbatical, I would have never seen that in September and I would have never made that bet. It’s because I had been freed up. 

I didn’t need to be hitting singles because I came back then it was clear and I was fresh. It was like the beginning of the season. I wasn’t hitting bad but it is really, really important if you’re a money manager to know when you’re seeing the ball.

Stig Brodersen  23:21  

To me this was a very interesting response, because what he’s talking about here is how fund managers are really incentivized and how they’re working due to their incentives. 

Basically, he resets every year. That makes a lot of sense if you are a money manager, but I also want to put it out if you are a private investor and you probably are listening to this podcast, this is generally a crazy strategy. A loss of $1 the last day of the year is just as important as $1 loss in January. 

I’m not really seeing here that Druckenmiller is unethical. None at all. If anything, he is very ethical. He actually closed down his fund in August 2010 when he told his clients that he was returning the money, because he couldn’t sustain his 30-year record of beating the market, because he had so much money. 

To me that was a very ethical decision. Most money managers would probably continue and just collect their annual fee. 

I think this response was very interesting because it also tells you what you should look out for when you are investing together with a money manager. That’s also one of the reasons why I’ve never invested in private equity or hedge funds for that matter, because basically, you reward your money manager, not only by taking an annual fee, but also to take a cut of the profits. 

Consider this, if the portfolio is down 10% in October, you incentivize your money manager to take big bets on making a profit. So if there’s a slight probability to make a profit for the year, but a much larger probability to lose 4% of the portfolio, you are really giving him incentive to take an irrational risk.

Preston Pysh 25:05  

All right, so this is the point in the show where we play a question from the audience, but today’s is going to be a little bit different. Instead of playing the question, we’re going to read a question. 

Stig and I really wanted to cover this topic because this is something that we’ve never been asked before. So what I’m going to do right now is I’m going to read out loud the email that we received from our listener, Sarah. This is what Sarah wrote. 

“Hi, Preston and Stig My name is Sarah. Thanks so much for the show. My question is why our mutual funds disparaged while hedge fund managers like Ray Dalio are celebrated? I understand the outcomes are different in many scenarios, but the process of taking fees to actively manage money is the same. In fact, hedge funds take a lot more fees when you take into account the percentage of gains that they actually take from the limited partners. I look forward to hearing your response and thank you so much.”

All right, Stig. Let’s hear what you got.

Stig Brodersen  25:57  

Let’s talk about the difference between a mutual fund and a hedge fund. Hedge funds are managed in a much more aggressive fashion and take speculative positions in derivatives. They can also short sell stocks. Stan Druckenmiller and Ray Dalio would be examples of that. 

Now, hedge funds are only available to accredited investors who meet a specific set of criteria to qualify in terms of wealth and of how much money they make. Now, while there are many types of mutual funds, they generally do not take the same highly leveraged positions, which is also why they’re available to us retail investors.

I do want to say that if I could give a counter argument to what you’re saying about the celebration of hedge fund managers, I could mention Peter Lynch. He’s probably the most famous mutual fund manager. He managed the Magellan Fund and Fidelity Investments between 1977 and 1990. He averaged 29.2% annual return. He’s definitely a household name if you’re an investor.

Generally, however, I think you are right in arguing that hedge fund managers are more celebrated. I think there are a few reasons for that. Hedge funds, in general, they take on more risk and they also see more volatility. For that reason alone, you see some perform much better than mutual fund managers. 

Another thing is it’s easy to talk about how Ray Dalio came out of the financial crisis with a positive result, but it’s a lot harder for a mutual fund manager that is long only in equities, even though he might have the same skill set in evaluating the current market, because he does not have the same instruments available when everything crashes. 

One more thing is that generally hedge fund managers have more interesting stories to tell. I mean, consider this if you’re a value investor, saying that you bought a stock in that cemetery and just kept it there for 30 years because you felt that demand is pretty stable. 

No one’s going to listen to that. It’s a lot more interesting to hear stories about Stanley Druckenmiller reading price signals and Ray Dalio thinking that the dollar could appreciate or depreciate by 30%, and how to take a position on that. As an investing podcast, we are guilty of that celebration too.

Preston Pysh  28:22  

Sarah, I don’t have much to add to Stig’s comment, but I’ll say we really appreciate this question because it’s not a topic that we typically discuss or provide clarification on. 

As a token of our appreciation for sending in your question, we’re going to give you access to one of our free courses on the TIP Academy page on our website. The course that we’re going to give you is our intrinsic value course. 

Our intrinsic value course teaches people how to determine the value of an individual stock. It also teaches you how to think about the market cycle and when you’re buying your stock. It also teaches you some stuff about options trading. We’re really excited to give you this course. 

If anybody else out there wants to check out the course, you can go to tipintrinsicvalue.com or you can just go to our website and click on the Academy link at the top of the page and courses right there. If anyone else wants to leave a question on the show, go to asktheinvestors.com. If your question gets played on the show, you’ll get a free course.

Stig Brodersen  29:15  

Alright, guys, that was all that Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro 29:22  

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