Loren Fleckenstein Chats With Jack Schwager
I’ll admit it: Successful trading must be run as a business, but I read Jack Schwager’s Wizards books as much for inspiration and entertainment as for practical knowledge. The latest addition to his famous series delivers on all three counts. The author extracts from his newest class of Merlins the same mix of practical advice, memorable war stories and philosophical insight that made the two earlier Wizards books best-sellers.
In choosing subjects for Stock Market Wizards: Interviews with America’s Top Stock Traders, Schwager insisted on more than successful traders. He insisted on astounding traders. Not only do Schwager’s 14 subjects deliver exceptional returns, consistently, they do so with downside volatility a T-bill investor could admire. The new Wizards meet the same lofty performance standards set by their predecessors in Market Wizards (1989) and New Market Wizards (1992).
To tick off just a few batting averages, by the time Schwager put his manuscript to bed, Stuart Walton had realized a 115% gross average annual compounded return in the 1990s (92% to his clients after deducting fees). His lowest yearly return was 63% (excluding the 1999 partial year). Michael Lauer’s flagship fund achieved a gross average annual compounded return of 97% since its inception in 1993. The small-cap fund’s bogey, the Russell 2000, delivered a corresponding 13% return. The fund’s greatest peak-to-valley equity drawdown was 8.7%. Mark Minervini traded his account to a 220% average annual compounded return in the 5 1/2 years from mid-1994. During that time, he had one losing quarter, giving up a drawdown of less than 1%.
So much for outsized gains necessitating outsized risk. (Professor Malkiel, are you listening?)
Okay, not all Schwager’s interviewees neared or delivered triple-digit annual returns. Money manager Dana Galante turned in a compound annual return of 15% during 1994-99. No big deal? Galante accomplished that feat as a pure short seller! Furthermore, 80% of her trades are in Nasdaq stocks. Over the same timeframe, the Nasdaq Composite Index appreciated by a yearly average of 32%. Schwager aptly puts Galante’s achievement in perspective. Galante’s performance, he writes, compares to “a mutual fund manager averaging a 15 percent annual return during a period when the stock market declines by an average of 32 percent annually. In both cases, overcoming such a powerful opposite trend in the universe of stocks traded requires exceptional stock selection skills.”
That extraordinary performance has attracted enough capital that Galante has closed Miramar Asset Management fund. Most of Galante’s clients use her short-selling to balance their longs. As Schwager observes in Stock Market Wizards: “Most people don’t realize that a short-selling strategy that earns more than borrowing costs can be combined with a passive investment, such as an index fund or long index futures, to create a net investment that has both a higher return than the index and much lower risk.”
Hubris, listening to tips and gambling impulses have been the downfall of many traders. If you know yourself to have any of these faults, don’t automatically rule out your potential. The Wizards fess up to the same shortcomings. A number deliver surprisingly candid accounts of disasters early in their careers and how they came back to become super-successful disciplinarians. The key lies in recognizing your weaknesses, then addressing them through discipline and a trading approach adapted to your personality. That adaptation should include your trading environment as well as your trading style.
Until starting a recent sabbatical, Stuart Walton worked in complete solitude, with not even a secretary to help him manage a $150 million fund. Was this a mark of go-it-alone machismo? Quite the contrary. In his interview with Schwager, Walton said: “I found that having another opinion in the office was very destabilizing. My problem is that I am very impressionable. If I have someone working for me every day, he may as well be running the money because I’m no longer making my own decisions.”
By contrast, money manager Steven Cohen (average trading profits 90% per year) prefers a team approach. He told Schwager: “I’m not a lone wolf. Many traders like to fight their own battles. I prefer to get a lot of support. The main reason I am successful as I am is that I’ve built an incredible team.”
As traders, we all must strike a balance between knowing when the market offers optimal conditions for our style of trading and when it does not. Thanks to Schwager’s drawing from such a diverse group of trading styles, you can find advice to spot such turning points — by reading the interviews of Wizards who practice a style opposite your own. I trade fundamental growth/price momentum. While I naturally gravitate toward the interviews of Wizards who use similar strategy, who better to give me a reality check than a genius practitioner of a value strategy? In Schwager’s interview value-focused money manager Michael Lauer, I found wise counsel for a growth trader looking out for vulnerability in high-momentum stocks.
Anticipating the bursting of Microsoft’s bubble, Lauer pointed out an ominous convergence of over-ownership, weakening fundamental growth and stratospheric valuation in the software giant. At the time of the interview (May 1999), Microsoft’s market cap exceeded $600 billion, a valuation of 20 times annual revenue. At that level, Lauer noted the market valued “Microsoft higher than the total GDP for Canada, a G7 member. And this for a company whose growth rates have been diminishing and whose primary product line — computer operating systems — is threatened with obsolescence by alternative solutions.” Meanwhile, 95% of Microsoft stock was in the hands of institutions.
Lauer asked: “Who is going to absorb all that supply if Fidelity and other benchmarking copycats decide to reduce their holdings?” Who indeed?
What helps Lauer decide timing for such a short? SEC filings of mutual fund holdings. Even given the reporting lag, Lauer is convinced reports of institutional selling in over-owned stocks is timely enough for super-inflated, hugely held stocks. There’s ample time on the way down to catch the move. Nor does Lauer fear false signals. “I’m looking for someone with a huge share position that is beginning to sell. We may trade around a position. The big mutual funds don’t do that. They either buy, sell, or hold.”
Whether you trade long or short, the Wizards drive home the point that they trade stocks, not companies; and ultimately, stock prices are driven by expectations, not fundamentals. Lauer notes his fund shorts “unreasonable Wall Street expectations, not inferior quality companies.” Or as Galante notes: “A good company could be a bad stock and vice versa.”
For a few other highlights:
Ahmet Okumus, who relies heavily on cues from insider transactions: “I compare the amount of stock someone buys with his net worth and salary. For example, if the amount he buys is more than his annual salary, I consider that significant.”
Minervini on paper-trading: “If you’re a beginning trader, trade with an amount of money that is small enough so that you can afford to lose it, but large enough so that you will feel the pain if you do. Otherwise, you’re fooling yourself. I have news for you: If you go from paper trading to real trading, you’re going to make totally different decisions because you’re not used to being subjected to emotional pressure. Nothing is the same. It’s like shadow boxing and then getting into the ring with a professional boxer. What do you think is going to happen? You’re going to crawl up into a turtle position and get the crap beat out of you because you’re not used to really getting hit.”
Mark D. Cook: “The best trades work the quickest. I found that you should make three points within the first 10 minutes. After ten minutes, the trade could still work, but the odds are much lower. Once you get to fifteen minutes, the odds are so reduced that all you want to do is get out the best you can. The more time that goes by, the lower the probability that the objective will be reached.”
Steve Watson, explaining why he will cover a short moving against him even if he remains bearish. “I have seen too many instances of companies where everything is in place for the stock to go to zero in a year, but it first quintupled because the company made some announcement and the shorts got squeezed. If that stock is a 1 percent short in our portfolio, I’m not going to let it turn into a 5 percent loss.”
Galante on forecasting a deterioration in earnings: “One thing I look for is companies with slowing revenue growth who have kept their earnings looking good by cutting expenses. Usually, it’s only a matter of time before their earnings growth slows as well. Another thing I look for is a company that is doing great but has a competitor creeping up that no one is paying attention to. The key is anticipating what is going to affect future earnings relative to market expectations.”
I could go on plucking plums from Stock Market Wizards until infringing on Jack Schwager’s copyright. Instead, let’s talk with the author himself.
Loren Fleckenstein: Welcome to TradingMarkets, Jack. The first Wizards book appeared more than decade ago. The many traders you’ve selected for your books represent wide variety of trading styles and personal backgrounds. Discretionary and systematic traders. Styles ranging across growth, value; momentum, contrarian. Short-sellers, long traders, arbitrageurs. Academics and people who quit secondary school or college. Men and women. Are there common threads among this diverse group? And does anything distinguish your newest Wizards from their predecessors?
Jack Schwager: I find that the personal traits of highly successful traders tend to be fairly time insensitive. They virtually all have a desire or drive to work to such an extent that others might consider it excessive. They also have extraordinary discipline and patience. I saw those elements in almost everybody whom I interviewed, whether it was a dozen years ago or now.
Fleckenstein: Obviously, just beating the S&P 500 falls far short of being chosen a Wizard. How do you choose the traders profiled in your books?
Schwager: I don’t think beating the S&P by a few percent a year is terribly impressive. For one thing, that type of outperformance could be luck. If you have enough money managers, a certain number of them will beat the S&P. That doesn’t mean they have true talent. Ideally, I’m looking for people who deliver returns consistently in the 40% to 100% range, sometimes higher, and they’ve been doing that year after year without large drawdowns. Often, they have limited drawdowns to single digits. They’re not just beating the S&P; they’re obliterating it. And they’re doing it with less volatility. One my of favorite examples in the new book is (mutual fund trader) Steve Lescarbeau. The funds that he trades were down sharply last year, and he still made a 50% return. So bottom line, I’m looking for the spectacular story.
Fleckenstein: Did any candidates, and I won’t ask for names, come close to getting into the book but no cigar?
Jack Schwager: There were a number of interviews that I conducted, which were not used in the book. These fell into two categories. In one type of case, although the trader’s performance numbers were impressive, the interviews were too esoteric, and lacking in meaningful content or interesting anecdotes. If I couldn’t turn the material into what I considered a readable chapter, I didn’t use it. The other type of case was when a trader’s performance was at the borderline of what I considered for inclusion in the book, but then fell below that level due to a drawdown that occurred before the manuscript was complete. In one case, I really liked the interview, which had some great anecdotes, but the trader witnessed his worst drawdown ever and as a result his cumulative performance was not sufficiently better than the S&P 500 to warrant inclusion. It hurt to drop the interview, but I felt I had to.
Fleckenstein: Did the Nasdaq bear market account for this particular last minute elimination?
Schwager: No. I submitted my manuscript to the publisher in March when the market was still near its highs.
Fleckenstein: The vast majority of the Wizards are discretionary traders, people who regardless of their discipline still include a large dose of human judgment in their decision making. Very few depend on a mechanical systems. Ed Seykota, who was in the first Wizards book, was an exception. Have you found that it’s harder to achieve outstanding results with a Black Box vs. a well-disciplined but still discretionary approach?
Schwager: Yes. All the Market Wizards have a specific methodology, but most of them do not have systems. There’s a reason for that. It’s very difficult to develop a trading system that can realize tremendous returns with low risk. There are people who have systems that make a lot of money but have high volatility. Even in the case of Seykota, his phenomenal returns were still achieved with great volatility. When I went out to Nevada to interview him, I remember his pulling out this 15-foot-long graph, showing his equity appreciating from $10,000 up to $15 million. But along the way, it could drop from, say, $6 million down to $3 million. Getting back to the basic question, to come up with a system that has very high return and moderate risk is extremely difficult. Achieving those extraordinary reward-to-risk numbers almost always requires some human element. There are exceptions. Lescarbeau is a systematic trader. His system did achieve what I would have thought was impossible for trading systems: extremely high returns with very low risk. There are also hybrid traders. Someone like David Shaw, who does quant-type arbitrage, has an elaborate, mathematical, computerized approach looking at hundreds if not thousands of inputs. However, this is not what most people think of by trading systems. Cook to some extent is a systematic trader: He has very specific indicators, but he still uses a degree of judgment.
Fleckenstein: When I compare notes on favorite books with other traders, the Wizards books frequently come up. What kind of feedback have you received from your readers over the years?
Jack Schwager: It sounds self-serving to say it, but when I’m visiting different financial institutions, it seems like everybody I meet has read the books. I’ve had a lot of people come up and tell me that the books radically improved their trading, or write me letters saying that they finally succeeded in the market after reading one of my books. Lescarbeau told me that he developed his initial trading methodology by reading between the lines of the Gil Blake interview in The New Market Wizards.
Fleckenstein: I’ve heard that you’re starting a Wizard hedge fund. Can you tell us about that?
Schwager: It launched in September. It’s called the Market Wizard Fund of Funds. Because it is a hedge fund, I am not at liberty to address the investment specifics. As I was conducting interviews for Stock Market Wizards, and investing with some of these traders along the way, I quickly ran out of funds to invest. Then I realized that the only way I could ever invest in a broader spectrum of these traders would be to have a fund-of-funds vehicle. And I figured if I created it, other people would be interested in investing in it as well.
Fleckenstein: Which Wizards are running money in the fund?
Schwager: That’s proprietary. There are people in the fund who are not in the book and vice versa.
Fleckenstein: I’ve been struck by how many Wizards came close to disaster, or did suffer disaster, then pulled it together and went on to become incredibly prosperous traders.
Schwager: Yes, early in his trading career, Stuart Walton not only lost all his money but also took out a home equity loan and lost 75% of that. Then he bet the remainder of the loan on a tip, leveraged it up to 200%, and got out when the stock rallied. That trade was pure luck, and he realized it. After that experience, Walton got very disciplined. He realized that his flaws were listening to other people and acting on his gambling instincts. Since then, he has built up a phenomenal track record. Mark Cook not only lost all his money but went deeply in debt on one trade. It was an option trade in which he was short calls. These options were nearly worthless with just days to expire. Overnight, there was a merger announcement. After building up steady profits for years, he lost it all overnight. He could have declared personal bankruptcy, but it was against his character to do that. He worked two jobs, and over the course of five years, he got out of debt and repaid everything. After his catastrophic loss, he couldn’t trade for about two years. Then he started small and began trading it up. So you can fail miserably and still succeed tremendously.
Fleckenstein: Do you believe beginning traders should start small?
Schwager: Yes. For beginning traders, starting small is right because even if they happen to have a lot of money, there is a much larger likelihood of them making mistakes at the beginning. They might as well these mistakes with less money. Additionally, when things are not going well, it’s generally a good idea to trade smaller. That way you can’t do much damage, and you can wait until you get your confidence back. Cook has a sign sitting on his computer that says, “Get smaller.”
Fleckenstein: I can understand how compound returns can enable a person to rebuild lost capital. But how do these people regain their confidence and morale after such crushing defeats?
Jack Schwager: It’s probably different for every individual. In Stuart Walton’s case, he was reprieved by pure luck. By the way, if he had stayed in that trade much longer, he would have lost everything since the company underlying his stock eventually went bankrupt. He was so relieved that he had been spared that final disaster that it shocked him into a disciplined approach. The thing was, even though he had these setbacks, he had something inside him, some innate confidence in his abilities. In the case of Cook, he was completely demoralized initially, and not only because he had lost his money. He had lost his parents’ money as well. When he finally had that conversation with his mother, and in a mournful state told her that not only had he lost his money but theirs, she said, “So that’s all? I thought you had cancer.” That put it all in perspective. The next question his mother asked him was, “How long will it take you to make it back?” The fact that she still had confidence in him made him determined to succeed. That conversation for him was probably pivotal to pulling him out of his depression.
Fleckenstein: When you interviewed your subjects last year, many were absolutely convinced that the market was in a speculative bubble. Did they feel that the Internet and general technology euphoria was unique? Has the nature of the volatility beast changed?
Schwager: I don’t think it really has. At the time I was putting the book together, one trader drew the analogy between the Internet stocks and RCA in the 1920s when it went from a few bucks to several hundred, and then back down to a couple dollars again. What was true then was still true in the 1990s. The companies, culture and technology may change, but human nature and hence the markets don’t change. Euphoria often gives way to total collapse. We’ve seen that over and over again. Something I learned from Jim Rogers (one of the original Wizards) is that there is a common theme whenever you get these euphorias. The theme is “this time it’s different.” Jim was talking about when he went short gold several days — but several hundred dollars — before gold collapsed. At the time, people were justifying the enormous rally in gold by saying that gold was different from other commodities because it was a monetary unit. The same thing happened when the Japanese stock market exploded to PEs of 100-plus in the 1980s. People were saying that Japanese stocks were different because Japanese companies buy each other’s stock and they don’t sell. During the Internet bubble, people were saying Internet companies are different from other companies: They don’t have to have profits.
Fleckenstein: That brings up the efficient market theory. I’ve often felt that efficient market theorists should read the Market Wizards series after reading Burton Malkiel’s A Random Walk on Wall Street.
Schwager: (Laughs) His book is a very thoughtful, well written book. And it does have a lot of truth to it. Interestingly, though, this didn’t stop him from trading the market himself. As far as the efficient market hypothesis, certainly there are elements of truth, but I’ve seen too many people achieve performance results that would defy probability. Efficient market theory doesn’t explain why some people can return 100% year after year and have only single-digit drawdowns. When you talk to these traders, they express such strong conviction in the existence of edges in the market — and confirm their belief with performance — that it’s difficult to come away believing markets are completely random.
Fleckenstein: Maybe it’s not a choice between absolutes. Your Wizards do voluminous research on a daily basis and sift through hundreds, even thousands of potential trades, before the pulling the trigger. Perhaps markets are for the most part very efficient, as Malkiel holds. But great traders are adept at spotting the exceptional, high probability inefficiencies.
Schwager: I think that’s true. Someone like Ahmet Okumus may look at 10,000 stocks and come down to only 10 that he’s interested in. Mark Minervini looks at a tremendous number of stocks and comes down to only a handful that provide an acceptable trading opportunity. There can be a lot of randomness, but at any given point in time there are elements of non-randomness — in other words, situations where the odds strongly favor prices moving in a given direction. If you can perceive those elements, you have a good shot at a highly profitable outcome. That’s why patience is so important. Because the markets are efficient so often, you must wait for the inefficiencies to become apparent.