Stock Market Wizards

by Jack D. Schwager

  * * *

  LTCM—a hedge fund headed by renowned former Salomon bond trader John Meriwether and whose principals included economics Nobel laureates Robert Merton and Myron Scholes—was on the brink of extinction during the second half of 1998. After registering an average annual gain of 34 percent in its first three years and expanding its assets under management to near $5 billion, LTCM lost a staggering 44 percent (roughly $2 billion) in August 1998 alone. These losses were due to a variety of factors, but their magnitude was primarily attributable to excessive leverage: the firm used borrowing to leverage its holdings by an estimated factor of over 40 to 1. The combination of large losses and large debt would have resulted in LTCM’s collapse. The firm, however, was saved by a Federal Reserve coordinated $3.5 billion bailout (financed by private financial institutions, not government money).

  * * *

  With all the ventures you have going, do you manage to take any time off?

  I just took a week off—the first one in a long time.

  So you don’t take much vacation?

  Not much. When I take a vacation, I find I need a few hours of work each day just to keep myself sane.

  You have a reputation for recruiting brilliant Ph.D.s in math and sciences. Do you hire people just for their raw intellectual capability, even if there is no specific job slot to fill?

  Compared with most organizations, we tend to hire more on the basis of raw ability and less on the basis of experience. If we run across someone truly gifted, we try to make them an offer, even if we don’t have an immediate position in mind for that person. The most famous example is probably Jeff Bezos. One of my partners approached me and said, “I’ve just interviewed this terrific candidate named Jeff Bezos. We don’t really have a slot for him, but I think he’s going to make someone a lot of money someday, and I think you should at least spend some time with him.” I met with Jeff and was really impressed by his intellect, creativity, and entrepreneurial instincts. I told my partner that he was right and that even though we didn’t have a position for him, we should hire him anyway and figure something out.

  Did Bezos leave your firm to start Amazon?

  Yes. Jeff did a number of things during the course of his tenure at D.E. Shaw, but his last assignment was to work with me on the formulation of ideas for various technology-related new ventures. One of those ideas was to create what amounted to a universal electronic bookstore. When we discovered that there was an electronic catalog with millions of titles that could be ordered through Ingram’s [a major book distributor], Jeff and I did a few back-of-the-envelope calculations and realized that it ought to be possible to start such a venture without a prohibitively large initial investment. Although I don’t think either of us had any idea at the time how successful such a business could be, we both thought it had possibilities. One day, before things had progressed much further, Jeff asked to speak with me. We took a walk through Central Park, during which he told me that he’d “gotten the entrepreneurial bug” and asked how I’d feel about it if he decided he wanted to pursue this idea on his own.

  What was your reaction?

  I told him I’d be genuinely sorry to lose him, and made sure he knew how highly I thought of his work at D. E. Shaw, and how promising I thought his prospects were within the firm. But I also told him that, having made a similar decision myself at one point, I’d understand completely if he decided the time had come to strike out on his own and would not try to talk him out of it. I assured him that given the relatively short period of time we’d been talking about the electronic bookstore concept, I’d have no objections whatsoever if he decided that he wanted to pursue this idea on his own. I told him that we might or might not decide to compete with him at some point, and he said that seemed perfectly fair to him.

  Jeff’s departure was completely amicable, and when he finished the alpha version of the first Amazon system, he invited me and others at D. E. Shaw to test it. It wasn’t until I used this alpha version to order my first book that I realized how powerful this concept could really be. Although we’d talked about the idea of an electronic bookstore while Jeff was still at D. E. Shaw, it’s the things Jeff did since leaving that made Amazon what it is today.

  * * *

  Shaw’s trading approach, which requires highly complex mathematical models, vast computer power, constant monitoring of worldwide markets by a staff of traders, and near instantaneous, extreme low-cost trade executions, is clearly out of the reach of the ordinary investor. One concept that came up in this interview, however, that could have applicability to the individual investor is the idea that market patterns (“inefficiencies” in Shaw’s terminology) that are not profitable on their own might still provide the basis for a profitable strategy when combined with other patterns. Although Shaw disdains chart patterns and traditional technical indicators, an analogous idea would apply: It is theoretically possible that a combination of patterns (or indicators) could yield a useful trading model, even if the individual elements are worthless when used alone.

  This synergistic effect would apply to fundamental inputs as well. For example, a researcher might test ten different fundamental factors and find that none are worthwhile as price indicators. Does this imply that these fundamental inputs should be dismissed as useless? Absolutely not. Even though no single factor provides a meaningful predictor, it is entirely possible that some combination of these inputs could yield a useful price indicator.

  Another important principle that came up in this interview concerns the appropriate methodology in testing trading ideas. A trader trying to develop a systematic approach, or any approach that incorporates computer patterns as signals, should caution against data mining—letting the computer cycle through the data, testing thousands or millions of input combinations in search of profitable patterns. Although the expense of computer time is usually no longer an issue, such computational profligacy has a more critical cost: it will tend to generate trading models (systems) that look great, but have no predictive power—a combination that could lead to large trading losses.

  Why? Because patterns can be found even in random data. For example, if you flipped one million coins ten times apiece, on average, about 977 of those coins would land on heads all ten times. Obviously, it would be foolish to assume that these coins are more likely to land on heads in the future. But this type of naive reasoning is precisely what some system developers do when they test huge numbers of input combinations on price data and then trade the combination that is most profitable. If you test enough variations of any trading system, some of them will be profitable by chance—just as some coins will land on heads on every toss if you flip enough coins. Shaw avoids this problem of data mining by requiring that a theoretical hypothesis precede each computer test and by using rigorous statistical measures to evaluate the significance of the results.

  * * *

  Update on David Shaw

  The D. E. Shaw group’s equity and equity-linked strategies have continued to roar ahead in recent years, with performance actually improving despite a significant increase in assets managed in these strategies over this period. The strategies were up 58 percent in 2000, 23 percent in 2001, and an estimated 22 percent during the first nine months of 2002 (in net terms). As a result, the average annual compounded return of these strategies during their nearly fourteen-year history has now risen to over 24 percent, applying current fees. The lifetime Sharpe ratio (a return/risk measure) is now about 2.00, an extraordinarily high figure for such a long track record.

  Your performance alone during the past 3½ years would have led to a tripling of assets under management. How much are you currently managing in your equity and equity-linked strategies? Has the increase in assets led to capacity problems?

  We’re currently managing around $4.3 billion, of which about $2.9 billion is in our equity and equity-linked strategies. At this point, the demand for our investment management services is sufficiently strong that we could easily raise
more capital, but it’s important to us to avoid accepting more money than we believe we can invest effectively. Although the capacity of these strategies has increased over the past few years as a result of new research results and certain market-related factors, the amount we’re managing is still limited by capacity rather than the availability of capital.

  Since you are often managing close to your estimated capacity in some strategies, what happens when your own positive performance causes assets under management to grow beyond this perceived capacity level?

  We return profits to investors to an extent sufficient to bring our assets under management back to the desired level.

  Have there been any significant changes to your methodology since we first spoke?

  The basic methodology remains unchanged for the bulk of our strategies. We have, however, added several newly researched market effects to the couple of dozen we were already trading. We’ve also launched a new strategy focusing on the distressed securities markets.

  Do the market effects or inefficiencies you trade have only limited life spans?

  It depends. The market anomalies that are relatively easy to spot and exploit tend not to last. However, more subtle inefficiencies that require complex quantitative techniques to identify and extract tend to persist for a longer period of time. These are the types of inefficiencies we tend to focus on, rather than the much simpler effects that are not likely to last. Over the years, we’ve had to retire only a few effects out of the many that we trade.

  Any thoughts about the corporate and accounting scandals we’ve seen recently?

  I believe the regulatory and legislative scrutiny that the corporate world is experiencing right now is very healthy. A number of CEOs and CFOs were playing close to the edge—and in some cases, as we’re now seeing, over the edge—in “managing” their earnings and executing dubious complex financial maneuvers to obscure the true health of their companies. This type of activity undermines the effective functioning of the global capital markets and should be of serious concern to a nation that has historically been a leader in accounting transparency. It’s a very positive development that steps are being taken to ensure that investors and analysts have access to accurate, reliable information about the companies in which they invest.

  * * *

  STEVE COHEN

  The Trading Room

  “He’s the best,” said an industry contact, referring to Steve Cohen, when I asked him to recommend possible interview candidates. I would hear virtually the same assessment repeated several more times whenever Cohen’s name was mentioned by industry acquaintances. When I looked at Cohen’s numbers, I understood the reason for their ebullient praise. In the seven years he has managed money, Cohen has averaged a compounded annual return of 45 percent, with only three losing months in the entire period—the worst a tiny 2 percent decline.

  These numbers, however, dramatically understate Cohen’s trading talent. Cohen is so good that he is able to charge a 50 percent profit incentive fee, which means that his actual trading profits have averaged approximately 90 percent per year. Despite stratospheric fees—approximately two and a half times the hedge fund industry average—Cohen has not had a problem attracting investors. In fact, his flagship fund is closed to new investment.

  Cohen’s firm, S.A.C., which derives its name from his initials, is located in an office building whose architectural style can best be described as “Connecticut Corporate”—a low-rise, rectangular facade of glass squares. I expected to find Cohen sitting in a window-encased office with a glass and steel desk. Instead, the receptionist led me into a huge, windowless room with six long rows of desks, seating approximately sixty traders, each trader with an array of six to twelve computer screens. Despite its size, the room was so filled with people and equipment that it felt more cavelike than cavernous. The absence of windows created a bunkerlike atmosphere.

  The traders were all dressed casually, with attire ranging from T-shirts and shorts, which was appropriate for the weather, to jeans or slacks and polar fleeces for those who found the air conditioning too cold. Cohen was seated near the middle of one row of desks, totally indistinguishable from any of the other traders in the room. (He was one of the polar fleece contingent.) Cohen has used his trading success to lure traders specializing in a whole range of market sectors. He has chosen to surround himself with traders, figuratively and literally.

  When I arrived, Cohen was in the midst of a lengthy phone conversation—ironically, he was being interviewed by The Wall Street Journal. (“This is media day down here!” Cohen would later exclaim to a caller, referring to the dual interviews.) I squeezed a chair in alongside Cohen’s slot within the room-length desk while I waited for him to get off the phone. Throughout his phone conversation, Cohen kept his eyes glued on the quote screens in front of him. At one point, he interrupted his conversation to call out an order. “Sell 20 [20,000] Pokémon.” As an aside to the rest of the room, he said, “My kids love it, but what the hell.” He reminded me of Jason Alexander from Seinfeld—a combination of a slight physical resemblance, speech patterns, and sense of humor.

  The room was surprisingly quiet, considering the number of traders. I realized what was missing—ringing phones; the order clerks had open lines to the exchange floors. Every now and then there would be a flurry of activity and an accompanying wave of increased noise. Traders continually shouted out buy and sell orders, news items, and queries to others in the room. Sample: “Anyone know—Is Martha Stewart going to be a hot offering?” Every couple of minutes, Cohen called out a buy or sell order to be executed, in a tone so casual that you might have thought he was placing an order for a tuna fish on rye, instead of buying or selling 25,000 to 100,000 shares at a clip.

  * * *

  What is the stock you shorted that has a product that your kids love?

  Nintendo. They do Pokémon. Do you know Pokémon?

  Afraid not. [This interview preceded the media crescendo that led to a Pokémon Time magazine cover.]

  It’s a Japanese cartoon character that is very popular right now.

  Why are you shorting it, if your kids like it?

  Because I think it’s a fad. It’s a one-product company. [Looking at the screen, Cohen comments] I think the market may go a little higher, but I’m actually turning very negative.

  Why is that?

  The big caps are moving higher, but the rally has no breadth. The market is moving up on light volume. Also, people will start to get more concerned about Y2K as we get closer to the end of the year.

  * * *

  A Fed announcement concerning interest rates is scheduled for the day I am visiting. As we approach within fifteen minutes of the announcement, Cohen begins entering a slew of buy and sell orders well removed from the prevailing market prices. “In case the market does something stupid,” he explains. In other words, he is positioning himself to take the opposite side of any extreme reaction—price run-up or sell-off—in response to the Fed report.

  Just before the announcement, the TV is turned on, just like in the movie Trading Places. (Although, for the record, the Trading Places sequence, which takes place on the commodity trading floor, is divorced from reality because the release of agricultural reports is deliberately delayed until after the close of the futures markets—but then again it’s only a comedy.) As the clock ticks down to 2 P.M., the tension and anticipation build. Cohen claps his hands and laughs, shouting in eagerness, “Here we go!” A minute before the announcement, a spontaneous rhythmic clapping—the let’s go [team name] beat one hears at sports events—ripples through the room.

  The Fed announcement of a ¼ percent hike in interest rates is exactly in line with expectations, and the market response is muted. There is a small flurry of trading activity in the room, which quickly peters out. “Okay, that was exciting, let’s go home,” Cohen jokingly announces.

  Cohen methodically types quote symbols into his keyboard at the rate of approximately one per
second, bringing up companies that are not on one of his numerous quote screens. The market begins to rally, and Cohen considers buying but then decides to hold off. Ten minutes later the market reverses direction, more than erasing its prior gains.

  * * *

  How much of what you do is gut feel?

  A lot, probably at least 50 percent.

  * * *

  I attempt to continue the interview, but it is virtually impossible with all the distractions and interruptions. Cohen is intently focused on his computer screens, frequently calling out trades, and also taking phone calls. The few questions and answers that I manage to record contain nothing that I wish to retain. The remainder of the interview, with the exception of the final section, is conducted in the more sedate environs of Cohen’s office.

  * * *

  When did you first become aware that there was a stock market?

  When I was about thirteen years old. My father used to bring home the New York Post every evening. I always checked the sports pages. I noticed that there were all these other pages filled with numbers. I was fascinated when I found out that these numbers were prices, which were changing every day.

  I started hanging out at the local brokerage office, watching the stock quotes. When I was in high school, I took a summer job at a clothing store, located just down the block from a brokerage office, so that I could run in and watch the tape during my lunch hour. In those days, the tape was so slow that you could follow it. You could see volume coming into a stock and get the sense that it was going higher. You can’t do that nowadays; the tape is far too fast. But everything I do today has its roots in those early tape-reading experiences.