Hedge Fund Market Wizards

Traders who are successful over the long run adapt. If they do use rules, and you meet them 10 years later, they will have broken those rules. Why? Because the world changed. Rules are only applicable to a market at a specific time. Traders who fail may have great rules that work, but then stop working. They stick to the rules because the rules used to work, and they are quite annoyed that they are losing even though they are still doing what they used to do. They don’t realize that the world has moved on without them.
Besides failure

In a situation like this where there is a binary outcome that is highly uncertain, but the probabilities are different from what the market seems to be pricing, do you participate in the market?
That is the main part of what I do. I look for deviations between the fundamental probability distribution I perceive and the probability distribution priced in by the market.
Being short Spanish debt is a trade where the downside is limited to the annual carry, but the upside can be very substantial. It seems that an inherent characteristic of most of your trades is that they have an asymmetric quality—the maximum loss is limited, but the profit potential is open-ended.

The economic downturn led to a big move in fixed income that provided a much calmer way to play that idea than a direct trade in equities.
So rather than consider the short side of the Nasdaq, you traded the long side of the bonds.

Yes, through options. The problem with markets like silver is that when they break, they can collapse rapidly, and there is gap risk. I think the natural way to trade a market that is in a bubble is from the long side, not the short side. You want to be long the exponential upmove without taking on the gap risk of a collapse. Therefore options provide a good way of doing this type of trade.

Gold is the only commodity where the amount of supply is literally about 100 times as much as the amount physically used in any year. That is not true of any other commodity, such as wheat or copper, where total supply and annual consumption are much closer in balance, and true shortages can develop. There is never any shortage of gold. So gold’s value is entirely dependent on psychology or those fundamentals that drive psychology. Many years ago, when I was a commodity research director, I would totally ignore gold production and consumption in analyzing the market. I would base any price expectation entirely on such factors as inflation and the value of the dollar because those are the factors that drive psychology.

It can be any price. Gold is worth exactly what people think it’s worth.

I guess that sometimes the reason for a bull market is psychological rather than fundamental, and participating in the euphoria of a psychological move is itself the rationale for the trade

For example, in late 2010, my underlying belief that the European sovereign debt crisis was a really big problem made it hard for me to participate in a sentiment and liquidity driven bull market. I failed to take part in the biggest macro theme of the year. From September on, equities were up a lot, and commodities were up a lot. It was a massive opportunity that I should have been in, and I wasn’t. I missed the key point that no one else cared, and as long as no one cares, there is no crisis. It’s the same reason I didn’t make any money in the Nasdaq bubble. I thought, “I can’t buy Pets.com.”

The managers who are relentlessly bullish and who buy more every time the market goes down will be the ones who end up managing most of the money. So, you shouldn’t expect a big bull market to end in any rational fashion.
The smart managers will be managing less because they don’t look as good as the bulls, since they’re going to have lower net long exposure?
Right. Because the bulls control most of the money, you should expect the transition to a bear market to be quite slow, but then for the move to be enormous when the turn does happen. Then the bulls will say, “This makes no sense. This was unforeseeable.” Well, it clearly wasn’t unforeseeable.
I have to laugh when I hear people say it was unforeseeable that housing prices could go down. I think, “Did you ever look at a housing price chart?” If you look at a long-term inflation-adjusted chart of housing prices, you can see that excluding the postdepression bust, since the 19th century, housing prices consistently moved in a sideways range, until the mid-2000s when inflation-adjusted prices nearly doubled in a few years. It sticks out like a mountain in a plateau. Yet people can claim with a straight face that they were shocked that housing prices could go down after that abnormal surge.
If you live in a world where everyone assumes that everything goes up forever, then it is inconceivable that prices might go down. Big price changes occur when market participants are forced to reevaluate their prejudices, not necessarily because the world changes that much. The world really didn’t change that much in 2008. It was just that people finally noticed there was a problem.
Consider the current U.S. debt problem. A lot of people say there is apparently no inflationary threat from the growing U.S. debt because bond yields are low. But that’s not true. Bond yields will only signal that there is a problem when it is too late to fix it. You have to believe in market efficiency to believe that the market will adequately price fiscal risk. Could there be a crisis in five years? Sure. Why? Because people start to care. Currently, it’s not in the price. But one day, it might be. If a major financial catastrophe happens, people will talk about how it was caused by this event or that event. If it happens, though, it will be because there were fundamental reasons that were there all along.
There will always be something that happens at the same time. Calling it a catalyst isn’t very helpful in explaining anything. Did World War I start because the Archduke was assassinated? Well, kind of, but mainly not. I don’t subscribe to the catalyst theory of history. But most people love it, especially in markets, because they can point to that one cause and say, “Who knew that could happen?”
When you have tremendous fundamental imbalances, the change can occur anywhere along the way. Nasdaq topped above 5,000, but it could just as well have been 3,000 or 7,000. It just happened to top above 5,000. Predicting the top of a bubble is like trying to predict the weather one year out—the same set of conditions can lead to wildly different outcomes if replayed multiple times.
Absolutely right, and I can’t predict that turnaround. It’s very difficult. But you can notice when things have changed. Most people, though, don’t. When Nasdaq is at 4,000 after having been at 5,000, there are lots of people buying it because it is cheap. They reason, “It used to be 5,000. Now it’s only 4,000. I am getting a bargain.” People are very poorly attuned to making decisions when there is uncertainty. Do you know the difference between risk and uncertainty?
Do you mean that in the realm of risk, you know the odds, but with uncertainty, you don’t know the odds?
Right. If you play roulette, you are in the world of risk. If you are dealing with possible economic events, you are in the world of uncertainty. If you don’t know the odds, putting a number on something makes no sense. What are the odds of Germany leaving the euro in the next five years? There is no way of assigning a probability. If you try to force it by saying something like “6.2 percent,” it is a meaningless number because you would have to behave as if you believed it, and that would be a poor bet.

1992 was based on something that had already happened—an ongoing deep recession that made it inevitable that the U.K. would not maintain the high interest rates required by remaining in the ERM. Afterward, everyone said, “That was incredibly obvious.” Most of the great trades are incredibly obvious. It was the same in late 2007