Some Deep Thoughts on Investment Strategies, Hedge Funds and Dreams

When I was an engineering student at UNM, I took a macro economic class and learned among other things that the economics principles came quite naturally to me. After years of not loving my classes and near burnout as I bounced around different engineering majors, I quickly changed majors to Economics. I remember reading some principles outlined in the very first macroeconomic text book we were taught out of at UNM and going, “Oh man, that’s one of my new theories! I didn’t know somebody else had already thought of it.”

I felt a bit of a flashback to those emotions of “Wait, some of these are my theories!” occasionally while reading the book, More Money Than God: Hedge Funds and the Making of the New Elite, even as I learned so much valuable information in this very well researched history of the strategies of the hedge fund icons of the 20th century. I’m serious: One of the more interesting things about many of the strategies in the book that created the first billionaire hedge fund managers is how many of them would be strikingly familiar to my long time followers.

Some of them, like George Soros’ theory of reflexivity, I’ve cited repeatedly over the years. Other strategies in the book that you’d find empirically familiar include this one from Paul Tudor Jones II:

“Jones approached trading as a game of psychology and bluff poker… It was not enough to look at your own cards and decide what you might bet; you had sense what other traders were up to — whether they felt greedy or afraid, whether they were poised to all in or were dangerously extended. You might hear bullish news for sugar, but then you had to ask yourself how others would react. If the big traders had already bought their fill, the news would scarcely budge the price; but if they were waiting to rush in, the market would take off like a rocket. The more you watched your rival traders, the more you knew how they would play; and eventually you could get inside their head.”

Here’s how I’ve written that:

“Trying to game earnings reports is one of the hardest and most volatile ways of trading. In fact, most technical analysts and many of the best traders I know abhor making a move when an earnings report is near. Long-term investors are best served by ignoring the often wild moves that a stock they own will make after an earnings report. That said, using a huge post-earnings selloff to scale into a stock you want to own for the long term is one of the best strategies for any investor’s playbook. When you try to game an earnings report, you’ve got to get three things right:

1. What the fundamentals of the last 90 days have shaped up to and whether the reported result is going to be better or worse than expected.

2. Know what the sentiment around the stock and the expectation for that earnings report is. If everybody’s expecting blowout numbers that can set a bar that’s too high to catalyze an earnings report pop. Vice versa if everybody’s expecting disaster and a collapse. It’s a version of the buy-the-rumor, sell-the-news dynamic that’s often inherent in trading.

3. Figure out the best way to trade the reaction to earnings that you expect after the company reports. Sometimes you can buy some near-term call or put options to benefit from a huge post-earnings move. Sometimes the premium on those options are too high to mess with, so you’re better off trying to buy/short the common stock itself.”

Then there was this one in a chapter from the book that focused so much on the idea of betting big when the upside potential is 10 or 100 times larger than the downside risk: “If there was one thing that [Druckenmiller] had learned from the master it was to pile on…when the right moment presents itself.”

You’ve heard me put that concept this way, back in 2011 for example:

“From a trading perspective the biggest threat to being aggressively long right here at DJIA 12k is simply the forces of seasonality.  June sucks for stocks, historically and it has so far this year too.  It’s rare that I even factor seasonality into my trading analysis at all, but the “Sell in May and go away” theory has empirically played out with such frequency that it does give me pause.  But that doesn’t mean we can’t have a big intra-month rally as the bears and shorts have gotten ever more aggressive and are now in the position of having to scramble and cover providing fuel to the upside if and when any kind of sustainable rally comes.  And of course, the underinvested professional money manager bulls will have to join any scramble as they’ll feel naked once any rally starts without them.

In addition to having spent the last few months and years preparing for this tech stock-boom-to-bubble that is now playing out according to plan, I’ve been getting more aggressive the last  couple weeks about buying and I do plan to continue buying both common stock and figuring out new option strategies to maximize our potential profits on any near-term rally.”

That’s from seven years ago in an article from the WSJ that I literally called “The bears are dead wrong: Why tech is about to take off” written back before most of our current portfolio stocks had gone up 300-1000% or more and I was indeed much more aggressive about “piling it on” unlike for the last year when I’ve been preaching being cautious because the risk/reward ratio hasn’t been nearly as good.

Another interesting point I want to share from the book is this direct quote from Paul Tudor Jones II: “Every evening I would close my eyes in a quiet places in my apartment. I would visualize the opening and walk myself through the day and image the different emotional states that the market would go through. I used to repeat that exercise every day, then when you get there, you have been there before. You are in a mental state to take advantage of the emotional extremes because you have already lived through them.”

That’s the same logic behind why you often hear me tell you to remember how you felt when the markets have had major 10-15% pullbacks when markets are ripping to new all-time high. And to be prepared to to use some big pullbacks to your advantage.

Relatedly, there was this fascinating article in the NYTimes this weekend that mentioned “According to one popular hypothesis, dreams evolved to serve an important psychological function: They let us work through our anxieties in a low-risk environment, helping us practice for stressful events and cope with trauma and grief.”

Now going back to the More Money Than God book, it notes that George Soros built his theory of reflexivity on the principles from philosopher Karl Popper (read this FT essay to learn from Soros himself how he built this off Popper’s theories, which is where I actually took this quote from, followed by the book’s interpretation): “I came to write my first major essay, entitled ‘The Burden of Consciousness.’ It was an attempt to model Popper’s framework of open and closed societies. It linked organic society with a traditional mode of thinking, closed society with a dogmatic mode and open society with a critical mode. What I could not properly resolve was the nature of the relationship between the mode of thinking and the actual state of affairs. That problem continued to preoccupy me and that is how I came to develop the concept of reflexivity—a concept I shall explore in greater detail a little later.”

The book puts it this way: “By now Soros had melded Karl Popper’s ideas with his own knowledge of finance, arriving at a synthesis that he called ‘reflexivity.’ As Popper’s writings suggested, the details of a listed company were too complex for the human mind to understand, so investors relied on guesses and shortcuts that approximated reality.”

Maybe all this goes back to Plato’s shadow cave theory.

1. Plato realizes that the general run of humankind can think, and speak, etc., without (so far as they acknowledge) any awareness of his realm of Forms.
2. The allegory of the cave is supposed to explain this.
3. In the allegory, Plato likens people untutored in the Theory of Forms to prisoners chained in a cave, unable to turn their heads. All they can see is the wall of the cave. Behind them burns a fire.  Between the fire and the prisoners there is a parapet, along which puppeteers can walk. The puppeteers, who are behind the prisoners, hold up puppets that cast shadows on the wall of the cave. The prisoners are unable to see these puppets, the real objects, that pass behind them. What the prisoners see and hear are shadows and echoes cast by objects that they do not see. Here is an illustration of Plato’s Cave:
   

1. Such prisoners would mistake appearance for reality. They would think the things they see on the wall (the shadows) were real; they would know nothing of the real causes of the shadows.

Let me try to summarize what we’ve looking at (and what we think we’re looking at, haha).

We have to look at the big picture, understanding that we can’t know everything and there could be new Black Swans or crisis or wars that will change our assumptions and what we think we know. We have to maximize our upside potential and minimize our risks with smart strategies that recognize the bubbles and crashes and dislocations and booms and busts and institutional forces that drive markets and economies. We have to be cognizant of others’ positioning and their psychology. We have to visualize the most likely scenarios and build our playbook accordingly. We have to have dreams — big dreams — and know that we can find stocks and other investment opportunities that can go up 5000% or 20,000% — (we’ve done it before after all). And that means need to keep letting our winners run and keep cutting losers. We have to trust our analysis but we have to be flexible and know that sometimes what we thought was real can just be a shadow.

Maybe the fact is that we’re on to something and how we’ve been using all these theories and strategies and tactics innately is a large part of what’s helped us have an edge in the markets for all these years (and hopefully to continue to do so).

All that said, here’s something else I want to note about all these hedge fund manager. You have to always be humble. These guys in this book have all had a terrible year here and there and many of them didn’t see the 2008 crash coming or more recently have been way underperforming while this Bubble-Blowing Bull Market that we nailed has been blowing for the last seven years.

The day you think you can just rest easy, sit on your laurels and coast is the day the markets slam home reality. It’s hard work. From the book one more last time:

“In December 1993, Michael Steinhardt escaped to his vacation home in Anguilla. His staff called in with regular updates and one afternoon the news was particularly pleasing. Steinhardt’s funds were up more than $100 million in a single day. ‘I can’t believe I’m making this much money and I’m sitting on a beach,’ Steinhardt marveled. It was an extraordinary moment, but one of his lieutenants counseled him to take it in stride, ‘Michael, this is how things are meant to be.’… Steinhardt could scarcely imagine that he was about to face humiliation.”

And losses from being complacent, greedy and, well, cocky.

There’s a lot of hard work, homework, risk/reward ratio analysis, investing and trading to do in the next 10,000 days. I’m on it.