soros 1

The London School of Economics was abuzz in 1949, when a young Hungarian named George Soros arrived there. The trauma of World War II was fresh; victims of Nazism, exiles from communism, and young leaders from Britain’s disintegrating empire found refuge together in London. There was a search for grand theories, for an understanding of how Europe had destroyed itself and how it could be rebuilt; the Labour government was refashioning Britain with its new welfare state, and Marshall aid was speeding reconstruction on the continent. In the LSE’s lecture halls, impassioned Marxists rubbed shoulders with the libertarian Friedrich Hayek; Keynesians and anti-Keynesians debated one another. It was in this era, as a historian of the school wrote, that “the myth of LSE was born.”1 Soros had already endured much by the time he arrived at the university. Born to a well-to-do Jewish family in Budapest, he had survived the Nazi occupation by separating from his family, assuming a Christian identity, and hiding with various of his father’s acquaintances. He had seen corpses in the streets of his city, mangled figures with bound hands and crushed heads, and he had helped his family survive by hawking jewelry to black-market dealers. In 1947, when he was barely seventeen, Soros had left Hungary for a better future in London, bidding good-bye 84 MORE MONEY THAN GOD to his parents, whom he expected not to see again. He took jobs as a dishwasher, a house painter, a busboy; a headwaiter told him that, provided he worked hard, he might one day end up as his assistant. The summer before Soros began his studies at LSE, he at last found a job he liked. He was a lifeguard at a swimming pool with not many swimmers. He read Adam Smith, Thomas Hobbes, and Niccolò Machiavelli. The LSE luminary who inspired Soros the most was Karl Popper, a philosopher who had fled his native Austria to escape Nazism—and who, in an entirely unintended way, stamped his ideas on the young man who was to become the most famous of all hedge-fund managers. Popper’s central contention was that human beings cannot know the truth; the best they can do is to grope at it through trial and error. This notion had an obvious appeal to someone of Soros’s background. It suggested that all political dogmas were flawed: The Nazism and communism inflicted upon Hungary by outside powers each claimed an intellectual certainty to which neither was entitled. Popper’s masterwork, The Open Society and Its Enemies, created in Soros a lifelong desire to make his own contribution to philosophy. It pointed him toward a distinctive way of thinking about finance and inspired the name of the philanthropy he was to found, the Open Society Institute. Soros left LSE with mediocre grades and spent a while in dead-end jobs, at one point selling handbags in northern Wales. He escaped this version of his destiny by writing to all the investment banks in the City of London, inquiring about entry-level positions. Spurned by the establishment because of his lack of social ties, he eventually landed a job with a brokerage run by Hungarian émigrés; after learning the fi nancial ropes, he found his way to New York in 1956, figuring he could stomach Wall Street for five years, long enough to put aside the savings he needed to support a life as an independent philosopher.2 But he soon found he was too good at the investing game to quit. By 1967 he was the head of research at Arnhold and S. Bleichroeder, a venerable Wall Street brokerage specializing in European stocks. And after getting to know the A. W. Jones segment managers by pitching ideas to them, he launched his own $4 million long/short stock-picking vehicle in 1969. He called it the Double Eagle Fund, and he managed it under the Bleichroeder umbrella.3 THE ALCHEMIST 85 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. But Soros was also conscious that those shortcuts had the power to change reality as well, since bullish guesses would drive a stock price up, allowing the company to raise capital cheaply and boosting its performance. Because of this feedback loop, certainty was doubly elusive: To begin with, people are incapable of perceiving reality clearly; but on top of that, reality itself is affected by these unclear perceptions, which themselves shift constantly. Soros had arrived at a conclusion that was at odds with the efficient-market view. Academic finance assumes, as a starting point, that rational investors can arrive at an objective valuation of a stock and that when all information is priced in, the market can be said to have attained an efficient equilibrium. To a disciple of Popper, this premise ignored the most elementary limits to cognition.4 Even as his financial career took off in the 1960s, Soros continued to hide away in the study of his weekend home, struggling to express his philosophy on paper. His ideas affected the way that he invested too, despite later suggestions that Soros superimposed the theory of refl exivity on his investment success as an after-the-fact rationalization. In an investment note written in 1970, Soros explained the workings of real-estate investment trusts in explicitly refl exive terms. “The conventional method of security analysis is to try to predict the future course of earnings,” he began; but in the case of these investment trusts, future earnings would themselves depend on investors’ perceptions about them. If investors were bullish, they would pay a premium for a share in a successful trust, injecting it with cheap capital. The cheap capital would boost earnings, which would in turn reinforce the appearance of success, persuading other investors to buy into the trust at an even greater premium. The trick, Soros insisted, was to focus neither on the course of earnings nor on the psychology that drove investors’ appetite. Rather, Soros homed in on the feedback loop between the two, predicting that each would drive the other forward until the trusts were so completely overvalued that a crash was inevitable. 86 MORE MONEY THAN GOD Sure enough, the real-estate investment trusts followed the boom-bust sequence that Soros expected. His fund made a fortune as they went up and another as they crashed downward.5 In 1973, Soros left Bleichroeder to set up his own company. He rented an office a block away from his co-op on Central Park West, bringing along his partner from Bleichroeder, an irascible, workaholic analyst named Jim Rogers. Interviewed years later in his Manhattan home, Rogers conducted the discussion while wincing and gasping on an exercise bike that was rigged up with a laptop and phone for maximum multitasking.6 Together with Rogers, Soros continued to look for moments when an unstable equilibrium might reverse. He saw, for example, that financial deregulation was changing the game in banking, transforming a dull sector of the stock market into a sexy one: He made a fortune from bank stocks. He spotted that the Arab-Israeli war of 1973 changed the game for the defense industry, since Soviet weaponry used by Egypt had performed well, demonstrating that the United States faced a greater challenge than previously imagined. Soros predicted that the Pentagon would soon persuade Congress to authorize some catch-up investments. He plunged into defense stocks.7 When Soros sensed a game-changing moment, he was not afraid to bet the store on it. After he decided military spending would go up, he became the largest outside shareholder in the defense contractor Lockheed. He was willing to take the plunge without waiting for conclusive evidence that he was right. If he found an investment idea attractive on cursory examination, he figured that others would be seduced too; and since he believed that perfect cognition was impossible, there was no point in sweating the details. On a skiing vacation once in Switzerland, he bought the Financial Times at the bottom of the chairlift, read on the way up about the British government’s plan to bail out Rolls-Royce, and called his broker from the top of the mountain with an order to buy British government bonds.8 Let specialists obsess about minutiae. Soros’s motto was “Invest first, investigate later.”9 By the start of 1981, Soros had achieved success beyond his wildest imaginings. His hedge fund, renamed the Soros Fund in 1973 and the Quantum Fund in 1978, had accumulated assets of $381 million, THE ALCHEMIST 87 multiplying its initial capital almost a hundredfold despite the tough equity markets of the 1970s. The teenager who had eked out a precarious living in London, sometimes relying on charities for support, had accumulated a personal fortune worth $100 million and was himself becoming a philanthropist. In June 1981, a reverential magazine profi le in Institutional Investor called Soros “the world’s greatest money manager.” Rivals expressed their admiration by echoing Ilie Nastase’s tribute to Bjorn Borg: “We’re playing tennis and he’s playing something else.”10 Soros was not above celebrating his own brilliance. “I stood back and looked at myself with awe: I saw a perfectly honed machine,” he wrote, with no apparent irony.11 “I fancied myself as some kind of god or an economic reformer like Keynes (each with his General Theory),” he confessed on another occasion. “Or, even better, a scientist like Einstein (reflexivity sounds like relativity).”12 But the tragedy was that he was not happy. Success as an investor required a visceral as well as intellectual focus on markets, which could be so intense as to be physical. If there was trouble stirring in his portfolio, Soros would first know about it when his back seized up; believing that markets could turn against him at any time, Soros would defer to these physical signals and sell out his positions. The business of investing consumed all the time and energy he had. He thought of himself as a boxer in training who had to sacrifice all personal life for the sake of victory. He compared himself to a sick person with a parasitic fund swelling inexorably inside his body.13 Even as he built success upon success, Soros began to rethink his priorities. In 1980 he parted company with Jim Rogers, whom he blamed for driving younger employees out of the firm, frustrating Soros’s hopes of spreading his workload; and he began to look for new partners to whom he could delegate responsibility.14 The distraction of the search caused his investment performance to crater. After gaining more than 100 percent in 1980, the Quantum Fund was down 23 percent the following year, its first-ever loss, and Soros was hit by a wave of redemptions that halved his capital from $400 million to $200 million.15 By September 1981 a humiliated Soros had entrusted the remaining money to other investors. Like Michael Steinhardt three years earlier, he took a break from the markets. 88 MORE MONEY THAN GOD WHEN SOROS RETURNED TO FULL-TIME INVESTING IN 1984, it was with a new sense of balance. Before, he had been paranoid that if he ceased to be paranoid his performance would suffer. But during his midlife crisis, a psychoanalyst had helped him to slay some of his demons. He recognized his success and permitted himself to relax, knowing that doing so might kill the golden goose, but also knowing that not doing so would render the success pointless. His visceral identifi cation with his fund ended; it was as though something physical had been excised from his body. He compared this change to a painful operation he had endured to extract a hard ball of calcium from his salivary gland. Once the stone was removed and exposed to the air, it crumbled to powder. “That is what happened to my hang-ups,” Soros recalled. “Somehow, they dissolved when they were brought to light.”16 Soros replaced the signals from his aching back with a more cerebral process. Starting in August 1985, he kept a diary of his investment thinking, hoping that the discipline of recording his thoughts would sharpen his judgments. The resulting “real-time experiment” is dense, repetitive, and filled with complex ruminations about scenarios that never in the end materialize. But because it is free of the biases that afflict retrospective explanations of success, it is a true portrait of the speculator at work. Moreover, Soros’s journal happened to capture one of his greatest triumphs—a bet against the dollar that he described as “the killing of a lifetime.” Soros had come out of the stock-picking culture of Wall Street. But his preoccupation with reflexive feedback loops led him to think broadly about opportunities. Like Michael Marcus of Commodities Corporation, who abandoned his seat on the floor of the cotton exchange to become a generalist trader, Soros saw no point in knowing everything about a few stocks in the hope of anticipating small moves; the game was to know a little about a lot of things, so that you could spot the places where the big wave might be coming. By the 1980s, the post–Bretton Woods system of floating currencies had emerged as a natural playground. The value of the THE ALCHEMIST 89 dollar was based on traders’ perceptions, which Soros naturally believed were flawed. And since these perceptions could reverse at any time, the dollar could move dramatically. This was not the conventional view of the way currency markets functioned. In the 1970s and into the 1980s, most economists believed that currency markets, like equity markets, tended toward an effi cient equilibrium.17 If the dollar was overvalued, U.S. exports would be hurt and imports would be boosted. The resulting trade deficit would mean that foreigners did not need as many dollars to buy American goods as Americans needed other currencies to buy foreign goods; the relatively low demand for the dollar would drive its value down, cutting the trade deficit until the system reached equilibrium. In the traditional view, moreover, speculators were in no position to disrupt this process. If they anticipated the currency’s future path correctly, they merely accelerated its arrival at the equilibrium point. If they judged wrong, they would slow its correction—but the delay would not persist because the speculators would lose money. Soros could see that equilibrium theory failed to explain how currencies actually behaved in practice. Between 1982 and 1985, for example, the United States had run a growing trade deficit, implying a weak demand for dollars; but over this period, the dollar had strengthened. The reason was that speculative flows of capital had pushed the dollar up; and these speculative flows tended to be self-reinforcing. When hot capital flowed into the United States, the dollar rose; the rising dollar drew in yet more speculators, driving the exchange rate away from equilibrium.18 If speculators were the real force determining exchange rates, it followed that currencies would exhibit a perpetual boom-bust sequence. In the first stage of the sequence, speculators would develop a prevailing bias, and this bias would reinforce itself, driving the exchange rate further and further from the level needed to achieve trade equilibrium. The more out of line the exchange rate got, the more the speculators would feel themselves confirmed, and the more the imbalance in trade would keep growing. Eventually, the pressure of enormous trade imbalances would 90 MORE MONEY THAN GOD overwhelm the speculators’ bias. A reversal would occur, the speculators would swivel 180 degrees, and a new trend would take off in the opposite direction.19 In the summer of 1985, the challenge that preoccupied Soros was how to judge the timing of the dollar’s reversal. When he began keeping his diary, on August 16, he suspected that the moment might be close at hand. President Reagan had reshuffled his administration at the start of his second term, and the new team appeared determined to bring the dollar down in order to reduce the U.S. trade deficit. The fundamentals, insofar as they were relevant, pointed the same way. Interest rates were falling, making it unrewarding for speculators to hold dollars. If the combination of political action and low interest rates could persuade even a few speculators to abandon the greenback, the upward trend in the currency could suddenly reverse. In the mature phase of a cycle, all the speculators who want to ride the dollar have already climbed aboard. There are hardly any buyers left, so it takes only a few sellers to make the market perform a U-turn. Soros agonized about whether the turn was imminent. If U.S. growth accelerated, interest rates would rise, making a dollar reversal less likely. On the other hand, if banks entered a cycle of credit contraction, in which falling collateral values and reduced lending fed back on themselves, the trouble in the banking sector could slow the economy sharply and push interest rates downward. “Who am I to judge?” Soros wondered; but then he added, “The only competitive edge I have is the theory of refl exivity.” The theory led him to weight the risk of a self-reinforcing banking mess especially heavily and so inclined him to bet against the dollar; besides, certain technical indicators pointed in the same direction.20 Having digested arguments from the quasi science of economics, the quasi philosophy of reflexivity, and the quasi psychology of the charts, Soros arrived at an investment conclusion. It was time to short the dollar. Despite his inner doubts, Soros plunged decisively. As of August 16, Quantum owned $720 million worth of the main currencies against which the dollar would fall—yen, German marks, and sterling—an THE ALCHEMIST 91 exposure that exceeded all the equity in the fund by a margin of $73 million. His appetite for risk was startling: “As a general rule, I try not to exceed 100 percent of the Fund’s equity capital in any one market,” he remarked breezily in his diary, “but I tend to adjust my definition of what constitutes a market to suit my current thinking.”21 The idea that a hedge fund should actually be hedged had been casually discarded. Three weeks later, on September 9, Soros’s second diary entry reported that his experiment had begun badly. The dollar had been buoyed by a batch of bullish U.S. economic indicators, and the currency bet had cost Quantum $20 million. Soros embarked on another bout of soulsearching. He continued to focus on the weak banking system, and the charts whispered that his luck might turn: The German mark appeared to be following a pattern that suggested a sharp rise might be coming. Then Soros brought a further dimension into his analysis. Putting himself in the shoes of the monetary authorities, he argued that interest rates were likely to stay low, even if the economy proved stronger than expected. The Federal Reserve would be reluctant to raise interest rates because of its responsibility as the regulator of the banks; the last thing that wobbly lenders need is more expensive capital. Moreover, the Fed would have room not to raise interest rates because Reagan’s reshuffl ed administration was determined to rein in the budget deficit, relieving infl ationary pressure. Weighing his options that September, Soros resolved to stick with his losing bet against the dollar, but to abandon half of it if the market moved further against him. Soros’s investment decisions were often balanced on a knife edge. The truth is that markets are at least somewhat efficient, so most information is already in the price; the art of speculation is to develop one insight that others have overlooked and then trade big on that small advantage. Soros would often pick through the evidence, formulate a thesis, but then turn on a dime; a stray remark from a lunch guest could tip the balance of the argument, and Soros would leap up and instruct a trader to get out of his positions.22 Soros’s decision to hold on to his dollar shorts in that second week of September was one of those close calls. If 92 MORE MONEY THAN GOD he had blinked after his initial loss, his life story would have turned out differently.23 But Soros did not blink. Less than two weeks after his second diary entry, on September 22, 1985, Treasury secretary James Baker assembled his counterparts from France, West Germany, Japan, and Britain at the Plaza Hotel in New York. Together the five powers promised coordinated intervention in currency markets to push the dollar downward. The news of the Plaza accord delivered Soros an overnight profit of $30 million. The yen rose more than 7 percent against the dollar the next day, its largest one-day jump in history. Soros had been somewhat lucky. He had seen clearly ahead of time that the Reagan administration wanted to manage the dollar down, but he had no idea how this intention would play out and no foreknowledge of the Plaza meeting.24 What happened after Plaza, however, was nothing to do with luck—and everything to do with Soros’s emergence as a legend. Rather than cashing in his bet against the dollar and resting on his laurels, Soros piled on harder. The turn in the dollar had finally come. Everything he knew about refl exive feedback loops argued that the dollar’s initial fall was merely the beginning. The Plaza Hotel meeting ended on a Sunday in New York, but it was already Monday morning in Asia. Soros immediately called brokers in Hong Kong with orders to buy additional yen for his portfolio. The next day, when his firm’s own traders began taking profits in the small subportfolios they ran, Soros succumbed to a rare moment of fury. He charged out of his office, yelling at the traders to stop selling yen and telling them that he would assume their positions.25 The traders had wanted to throw their arms around success before it ran away.26 But as far as Soros was concerned, the top governments of the world had telegraphed that the dollar was headed down. Plaza had given the signal, so why shouldn’t he hog more yen positions? Over the next days, Soros continued buying. By the Friday after the Plaza meeting, he had added $209 million to his holdings of yen and German marks and had established an extra $107 million worth of short THE ALCHEMIST 93 positions in the dollar.27 If there was a risk in this posture, it was that the Plaza communiqué would turn out to be a paper tiger; the declaration was suspiciously thin on actionable detail, and it depended on the uncertain commitment of governments to follow up with concrete measures. But more than any other New York fund manager, Soros had a web of political contacts in Washington, Tokyo, and Europe, and his network encouraged him to believe that Plaza was serious.28 By early December he had loaded up on another $500 million worth of yen and German marks, while adding almost $300 million to his short position in the dollar.29 “I have assumed maximum market exposure in all directions,” Soros recorded in his diary.30 In December 1985 Soros concluded the first phase of his real-time experiment. He looked back on a period that had begun with a hypothesis that the dollar was ripe for reversal and that had culminated with the theory’s confirmation. His repeated conjectures about a collapse in the banking system had turned out to be a red herring; “the outstanding feature of my predictions is that I keep on expecting developments that do not materialize,” he admitted.31 But the errors had been dwarfed by one central success. Soros had understood that nothing more substantial than slippery perceptions had driven up the dollar, and therefore that a trigger could set off a sudden reversal. Because he had grasped the system’s instability, he had understood the Plaza accord’s meaning faster than others. Plaza was the trigger, and it didn’t even matter that the details of the new policy had yet to be filled in. A political jolt had kick-started a new trend, which would now feed on itself and become self-sustaining. The rewards from the Plaza trade were astonishing. In the four months from August, Soros’s fund jumped by 35 percent, yielding a profit of $230 million. Convinced that the act of writing his diary had contributed to his performance, Soros joked that his profit represented the highest honorarium ever received by an author.32 When the diary was published two years later, as part of Soros’s book The Alchemy of Finance, reviewers mocked its dense prose. But as one commentator said, financial alchemy certainly beat boiling up mercury with egg yolks.33 94 MORE MONEY THAN GOD THE PUBLICATION OF THE ALCHEMY OF FINANCE IN MAY 1987 confirmed Soros’s status as a celebrity. The diary struck a chord with several of the younger stars in the hedge-fund firmament, who saw in it an honest picture of a speculator wrestling anxiously with multiple imponderables. Paul Tudor Jones, the whiz-kid cotton trader who had received seed capital from Commodities Corporation and later built the wildly successful Tudor Investment Corporation, made Alchemy required reading among his employees.34 In a foreword to Alchemy, Jones declared that, having published, Soros should now beware; and he invoked a scene from the World War II movie Patton, in which the great American general savors victory over Field Marshal Erwin Rommel. Patton has prepared for battle by reading Rommel’s tactical writings, and in a climactic moment in the movie, he peers out from his command post and delivers Jones’s favorite line: “Rommel, you magnificent bastard. I read your book!”35 Soros was having too much fun to fret about such warnings. At last he was becoming the kind of public intellectual he had admired at the LSE; and his expensively tailored figure, topped off with large glasses and a thick tangle of hair, began popping up on magazine covers. His Central European accent added to the exotic aura that surrounded him. Soros, said the profiles, had been a student of global investing years before most fund managers had discovered Tokyo on the map; he embraced futures, options, and forward currency contracts; he went long and short with equal facility. From his eerily quiet trading floor in Manhattan, he ruled over the markets of the world, hobnobbing with global financiers in fi ve languages.36 The Economist called him “the world’s most intriguing investor,” and a cover story in Fortune suggested he might rank ahead of Warren Buffett as “the most prescient investor of his generation.”37 But just as the flattering profile of Soros in Institutional Investor in 1981 had presaged that year’s humiliating 23 percent loss, so the adulation of 1987 presaged a calamity. The Fortune cover story appeared on September 28, 1987, and its title posed the question of the moment. “Are stocks too high?” the magazine THE ALCHEMIST 95 asked; after the long bull market that had begun at the start of the decade, the stocks in Standard & Poor’s index of four hundred industrial companies sold at an average of three times book value, the highest level since World War II. Fortune introduced Soros as its first expert witness on the stock market’s level, and it explained that Soros was sanguine. The fact that trend followers had driven the market upward did not mean that the crash was coming soon: “Just because the market is overvalued does not mean it is not sustainable,” Soros declared delphically. For evidence to support his view, Soros pointed to Japan, where stocks had soared even higher above traditional valuations. Eventually a crash would come. But it would hit Tokyo before Wall Street. Soros was not alone in being bullish. The following week Salomon Brothers issued a research note promising that the bull market would continue into 1988, and the week after that, Byron Wien, a well-known Morgan Stanley strategist and Soros friend, predicted “a new high before this cycle is over.” It was the era of the leveraged buyout, and debt-fueled takeovers were driving stock prices steadily higher; the lives of corporate raiders were the stuff of drooling magazine features. The mood of the moment was captured by a hitherto unknown financier named P. David Herrlinger, who announced a $6.8 billion offer for Dayton Hudson Corporation. Herrlinger appeared on his front lawn to tell reporters that his offer might or might not be a hoax—“It’s no more of a hoax than anything else,” he said—and the news of the apparent takeover sent Dayton Hudson stock into the stratosphere. But a hoax is what it was, and Herrlinger was soon removed to a hospital.38 The buyout mania neatly fitted Soros’s ideas on reflexivity. The takeovers were feeding on themselves: As each acquisition was announced, the stock of every company in the sector jumped, and the prospects of returning acquired companies to the stock market at a profit grew rosier. The avalanche of loans to finance deals kept on coming; the spiral drove prices further and further from any approximation of fundamental value, just as the Soros theory predicted. Of course, sooner or later the takeover deals would collapse under the weight of their own debt, and the trend would reverse itself. But there seemed no strong evidence that the reversal 96 MORE MONEY THAN GOD would come soon. Soros continued to pursue his new avocation as Wall Street’s philosopher-in-chief, holding court to journalists and appearing on television shows. On October 5 Soros invited one of his new fans over to his office. The guest was Stanley Druckenmiller, the hottest mutual-fund manager on the Street, who had read Alchemy and expressed an interest in a meeting. Soros held forth grandly and offered Druckenmiller a job.39 He wanted a successor who could run Quantum, leaving him more time for philosophy and philanthropy. Money management was wearing on him. Druckenmiller refused to be lured so easily, but the two struck up a close relationship. Druckenmiller was as tall and broad shouldered as Soros was compact; he was as plainspoken as Soros was complex; he was as unflashy and middle American as Soros was exotic and middle European. But the two got along well. Soros, then in his late fifties, would pontifi cate; Druckenmiller, still in his midthirties, had his ego suffi ciently in check to listen. And although they shared many views about the market, their funds were positioned differently. Druckenmiller had decided that a market break was coming, and he was short Wall Street; Quantum was short Japan but long the U.S. market. Indeed, Soros had recently added to his team of stock pickers, and Quantum was racking up eye-popping returns by loading up on the hot takeover stocks—the “garbitrage” stocks, as the wags of Wall Street called them. By riding the market wave, Soros’s team was up some 60 percent by the end of September. Everything was going wonderfully. On October 14 Soros published an article in the Financial Times reaffirming his view that the crash would arrive in Tokyo. That Wednesday morning, he headed off to Harvard’s Kennedy School to give a talk on boom-bust theory. After delivering his lecture, he emerged to fi nd that Wall Street had sold off. The newswires were reporting that Congress might raise taxes associated with corporate mergers, a move that could silence one engine of the bull market.40 The Dow Jones Industrial Average dropped 3.8 percent that day, a move that should have caught Soros’s attention. He knew that the market was far from equilibrium; he knew THE ALCHEMIST 97 that booms can be quickly followed by sharp busts. As he ruefully confessed later, “That’s when I should have been in the office and getting the hell out of the market.”41 On Thursday stocks continued to head down; and on Friday they dove precipitously. After the markets closed that day, Soros received a visit from his new confidant. The three-day sell-off had convinced Druckenmiller that the Dow had given up enough ground; according to his charts, prices had fallen to a point from which they would probably bounce upward. That Friday afternoon, Druckenmiller had switched from a short to a long position.42 Soros listened to his friend and spread a raft of charts in front of him. These had been prepared by Paul Tudor Jones, the other admirer of Alchemy, whom Soros also spoke with frequently. Druckenmiller examined the patterns and sensed a panic rising in his gut. Jones’s charts appeared to show that he had committed a disastrous error. The lines on the paper illustrated the stock market’s historical tendency to accelerate downward whenever an upward sloping parabolic curve had been broken, and they suggested a parallel between the market of 1987 and the market of 1929. Maybe a collapse was coming.43 The next morning Druckenmiller visited Jack Dreyfus, the patriarch of the Dreyfus family of mutual funds, where Druckenmiller was working. Dreyfus had instructed his secretary to keep charts not just of the broad market indices but of individual stocks. “We went over all these individual charts and I knew I was cooked,” Druckenmiller recalled later. “What I saw wasn’t a bunch of stocks that were necessarily down a lot. They had just broken out,” he said, meaning that they had broken out of a congestion point and would now accelerate downward. “Stock after stock after stock had just made a clean break right there. . . . Clearly I had misread the situation.”44 By focusing on the broad market, Druckenmiller had missed the alarming action in individual shares—and there is an old saying among chart watchers that soldiers lead generals. Druckenmiller was scared to death for the rest of the weekend. On Monday he bailed out of his positions as quickly as he could, and by late morning he had 98 MORE MONEY THAN GOD fl ipped 180 degrees. After a harrowing few hours, he was again short the market. That day, October 19, went down in history as Black Monday. The Dow Jones index lost 22.6 percent of its value, the largest drop since the venerable index had been launched ninety-one years earlier. By flipping his position so rapidly, Druckenmiller escaped the worst of the chaos, but the same was not true of Soros. He did his best to bail out of the market, but he was running more money than Druckenmiller; and the garbitrage stocks that had been riding high just days earlier were hard to unload in a panic. Around lunchtime, when Druckenmiller had completed his reversal but Soros was still desperately selling, the market descended into pandemonium. “People didn’t believe their stocks could go down that fast,” one Wall Streeter recalled later. She steadied herself by looking out of her window at a hot dog stand. So long as hot dogs were selling, the world could not be ending.45 On Monday evening Soros reassessed the situation. Wall Street had hit him hard, but his short position in Japan had paid off as the Nikkei stock index fell, cushioning his losses. There were rumors that the extraordinary collapse in New York had been caused by a newfangled instrument known as “portfolio insurance,” which promised investors protection against a market fall. The insurance worked by selling futures as the market weakened, putting a floor under an investor’s potential loss; but when thousands of insurance policies triggered futures selling in a weak market, the result was a meltdown unprecedented in history. If this account was right, there was an obvious message for Soros. A market collapse triggered by program trading rather than by fundamental factors was more likely to be corrected soon. Perhaps a rebound was coming. On Tuesday morning, sure enough, the market rallied. Soros seized the opportunity to pile back into the market. But his Japanese positions were hit by extraordinary bad luck. He had established his short position on the Nikkei index by selling futures in Hong Kong, where the market was more liquid. But when stocks collapsed on Black Monday, the masters of the Hong Kong futures exchange decided to staunch losses by closing it down, and when Wall Street began to rally on Tuesday, portending a rally THE ALCHEMIST 99 the next day in Japan, Soros could not get out of his short position. On Wednesday the Nikkei leaped 9.3 percent, its biggest one-day gain since 1949. Soros could do nothing.46 A few minutes before the markets closed in New York that Wednesday, Soros spoke again with Druckenmiller. The Dow had by now rallied strongly for two days, and Druckenmiller thought another turn was coming. He had studied the history of crashes, and he had seen a pattern: A sharp fall in the market was usually followed by a wild two-day rally, but then the market would collapse back to its low again.47 That Wednesday afternoon, Druckenmiller told Soros that he was short the market. Soros was not persuaded. He had consulted other confi dants, and was convinced that Black Monday had been a freak. It was a bad dream caused by portfolio insurance.48 Druckenmiller was an early riser and he woke up on Thursday morning nervous as a goat.49 The market had closed strongly the previous evening, and Soros might prove right that the historical pattern would not hold because of the anomaly of portfolio insurance. But when he checked in on the action in London, he saw that stocks were getting killed. If New York took its cue from London, Druckenmiller’s short positions would come good and Soros would be in trouble. Around 8:00 a.m., Druckenmiller got a call from the futures desk at Salomon Brothers. “There’s an elephant in the marketplace and the futures could open under two hundred,” the broker informed him. This was a bombshell. The futures had closed at 258 the night before; an instant fall to 200, under the pressure of this elephant trader’s selling, would represent a drop of almost a quarter. Druckenmiller figured that he might as well position himself for this drama in case it really did occur. He placed an order with the broker to close his short positions if the futures contracts fell to 195. At that rock-bottom level, Druckenmiller would be happy to take profi ts. The market opened, and the elephant crashed down upon it. The futures fell to 200 and below, and Druckenmiller’s orders with Salomon were all filled, yielding a 25 percent return on a position he had held only since the previous evening. By about ten o’clock in the morning, 100 MORE MONEY THAN GOD the elephant’s selling had been completed and the market stabilized, and Druckenmiller reckoned it was time for yet another flip in his position. Remembering the conversation of the previous afternoon, Druckenmiller picked up the phone and called Soros. “George, I just wanted you to know I was negative last night but I think maybe this is the bottom,” he told him. “Some crazy person just sold the hell out of this thing. Like, really recklessly.” Soros sounded calm, detached. “Right now I’m licking my wounds,” he said. “I’ll come back and fight another day.”50 It was not until that weekend that Druckenmiller realized what had happened. He picked up the newest edition of Barron’s and read that the elephant in the market had been none other than Soros.51 The full story, which Barron’s reported partially, was connected to the trouble in Japan. After its huge leap on Wednesday, Tokyo had risen again on Thursday. Soros wanted out of his short position in the futures market, but there was no way he could sell until the Hong Kong authorities reopened the exchange; meanwhile, he was bleeding money. Coming on top of the losses in the New York market on Monday, Quantum risked the sudden evaporation of confidence that can destroy any leveraged fund. Once your lenders sense you are in trouble, they start calling in their loans; the calls force you to sell stocks into a weak market, setting off a death spiral.52 When Soros saw the London market fall early on Thursday, portending another sell-off in New York, he decided it was time to jump for the sidelines. He had been too slow to get out of the market on Monday, and he did not want to let that happen twice in a week. “I don’t understand what’s going on,” he said. “We’ve just got to move to cash. There’ll be another day to play.” Then he gave the order to his trader, Joe Orofino, to get out of the market by selling S&P futures on the Chicago Mercantile Exchange; and Orofino placed the sell order with brokers at Shearson Lehman Hutton. Quantum’s entire $1 billion position was to be dumped, and quickly. But it was impossible to sell that size of position without moving the market. Traders in the futures pit began to sell frantically as soon as the Soros fire sale started, and investors such as Druckenmiller understood that they could allow the market to crash THE ALCHEMIST 101 through the floor before taking profits on short positions. “When they saw an order like that they made the market very, very low,” Soros later recalled, ruefully. 53 Soros’s decision to go to cash that day was perhaps the worst call of his career, costing his fund about $200 million.54 It capped a cataclysmic run: In roughly a week, Quantum had gone from being up 60 percent for the year to being some 10 percent down; $840 million had vanished.55 The episode demonstrated a weakness in hedge funds that would haunt the industry in later years: The larger the funds grew, the harder it became to jump in and out of markets without disrupting prices and damaging themselves in the process. If Quantum had been smaller, Soros might have bailed out on Monday as swiftly as Druckenmiller had; and he could have sold his position on Thursday without causing prices to crater. Soros’s trading style assumed the ability to turn on a dime, and when that assumption proved wrong, Soros was in trouble. THE SCALE OF THE CRASH DESTROYED THE CONFIDENCE of many money managers. Proud fi gures retreated into the fetal position: “I was so depressed that fall that I did not want to go on,” Michael Steinhardt recalled later; “my confidence was shaken. I felt alone.”56 Soros experienced only a mild echo of those sentiments. He was tired of running Quantum, as he had confided to Druckenmiller even before the crash; the option of quitting was always somewhere in his consciousness. But his nerve was not in doubt, not in 1987 nor, indeed, at any time, and within the community of Soros fans, the manner of his recovery after the crash ranks among his greatest accomplishments. A week or two after Black Monday, Soros spotted an opportunity to short the dollar, and he put on a gutsy, leveraged position as though nothing untoward had happened. The dollar duly fell, and the gamble paid off. Quantum ended 1987 up 13 percent, despite having languished in the red only two months earlier. In the wake of Black Monday, there had been inevitable sniggers. An anonymous source chortled to the Times of London, “It took 20 years to make George Soros a genius; four days to make him a jerk.”57 An item in 102 MORE MONEY THAN GOD Forbes recalled Soros’s unfortunate bullishness in the Fortune cover story of just weeks earlier. “If George Soros, the rich, immensely conceited and famous Hungarian-born money manager, appears beside a gushing headline on the cover of a business magazine, sell your stocks,” it sneered.58 The reports of Quantum’s setback quickly spread to eastern Europe, where there were fears that it would put an end to Soros’s philanthropy in the region; Soros flew to Hungary to reassure the prime minister that his giving would continue. But by the end of 1987, the rumors of Soros’s fi nancial death had been shown up as premature. Financial World listed Soros as the second-highest earner on Wall Street. The top dog was none other than Paul Tudor Jones, chartist and Patton afi cionado. The Lazarus act of 1987, coming on top of the killing during the Plaza accord two years earlier, cemented Soros’s status as an investment folk hero. But it had a wider influence as well, for Soros’s example did much to create what came to be known as the “macro” hedge fund, at least in its modern incarnation. From 1924 until his death in 1946, John Maynard Keynes invested the endowment, the College Chest, of King’s College, Cambridge, in the global markets, and although the term “hedge fund” did not yet exist, he employed many of the devices that modern macro managers would recognize. He speculated in currencies, bonds, and equities, and he did it on a global scale; he went both long and short, and he magnified returns with leverage. After World War II, stable infl ation, regulated interest rates, and immobile currencies caused Keynes’s tradition of macro investing to die out—ironically Keynes himself had helped to negotiate the fixing of exchange rates at the Bretton Woods conference. After the Bretton Woods system unraveled in the 1970s, macro investing began to stir again. But at first it did so tentatively. Two streams of investors helped to revive it. Equity types such as Michael Steinhardt realized that shifts in interest rates could drive the stock market, as we have seen; starting in the 1980s, they took the logical next step and bet directly on interest-rate movements by speculating in bonds, first in the United States and later internationally.59 Meanwhile, commodity investors such as Michael Marcus and Bruce Kovner started out trading cotton, gold, and so on; but as commodity markets created THE ALCHEMIST 103 new contracts on currencies and interest rates, they began to surf these instruments. Until the publication of Soros’s Alchemy, however, the equity and commodity traditions remained separate. The equity investors came from a culture dominated by fundamental analysis. The commodity traders came from a culture dominated by charts and trend following. But Soros’s example had something for both tribes. The real-time experiment in Alchemy combined fundamental analysis with a belief in trends; it combined the language of economists with the instincts of a chart watcher. In this way, Soros managed to communicate with both halves of the hedgefund house, reminding each that there was wisdom in the other.60 Within a few years, commodity people like Paul Tudor Jones and equity people like Stan Druckenmiller were regarded simply as “macro” investors.61 FOR YEARS AFTER THE CRASH, THE EVENTS OF BLACK Monday were picked over for some deeper meaning. Modern fi nancial engineering, which later blurred with hedge funds in the public mind, was blamed for the debacle. The engineers had created a destabilizing feedback loop: A fall in the market triggered insurance-based selling, which in turn triggered a further fall in the market and another insurance-based sell-off. Mark Rubinstein, a Berkeley economics professor and coinventor of portfolio insurance, descended into what he would later recognize as a clinical depression. He fretted that the weakening of American markets might tempt the Soviet Union to attack, making him personally responsible for a nuclear confl ict.62 Not for the first time, financial innovation was being blamed too eagerly. Soros had believed that portfolio insurance created Black Monday; but markets had crashed periodically throughout history, and foreign markets, in which there was far less portfolio insurance, also suffered precipitous falls. Even in the United States, the postmortems on the crash found that of the $39 billion worth of stock sold on October 19 via the futures and the cash markets, only about $6 billion worth of sales were triggered by portfolio insurers. Low-tech villains were just as important. Many investors had standing orders with brokers to sell if their positions 104 MORE MONEY THAN GOD fell, and these old-fashioned stop-loss policies may have accounted for at least as much selling as portfolio insurance. Besides, fears of a crash had been widespread in the run-up to the event, so there were psychological explanations for the mayhem too. A story in the Atlantic Monthly at the time was headlined “The 1929 Parallel,” and the Wall Street Journal ran a piece on the morning of Black Monday superimposing a graph of the market’s recent decline on a graph of the market of the 1920s.63 The tools of finance were, in the end, just tools. People bought portfolio insurance or put in stop-loss orders because of the skittish atmosphere of the moment. 64 Whatever the role of portfolio insurance, the larger lesson of the crash was different. Wall Street’s gyrations administered a crippling blow to the efficient-market theories that Soros had long criticized. Over the course of a week, the value of corporate America had bounced around like a pachinko ball; there was nothing efficient about this, nor was there any sign of equilibrium. “The theory of reflexivity can explain such bubbles, while the efficient market hypothesis cannot,” Soros wrote later, and broadly, he was right.65 It was surely no coincidence that effi cient-market thinking had originated on American university campuses in the 1950s and 1960s—the most stable enclaves within the most stable country in the most stable era in memory. Soros, who had survived the Holocaust, the war, and penury in London, had a different view of life; and after the wild ride of Black Monday, the academic consensus began to come around to him. The crash had been a humiliation for Soros in investing terms. But in intellectual terms it was a vindication. The recasting of the academic consensus had three parts to it. The efficient-market hypothesis had always been based on a precarious assumption: that price changes conformed to a “normal” probability distribution—the one represented by the familiar bell curve, in which numbers at and near the median crop up frequently while numbers in the tails of the distribution are rare to the point of vanishing. Even in the early 1960s, a maverick mathematician named Benoit Mandelbrot argued that the tails of the distribution might be fatter than the normal bell curve assumed; and Eugene Fama, the father of effi cient-market theory, THE ALCHEMIST 105 who got to know Mandelbrot at the time, conducted tests on stock-price changes that confirmed Mandelbrot’s assertion. If price changes had been normally distributed, jumps greater than five standard deviations should have shown up in daily price data about once every seven thousand years. Instead, they cropped up about once every three to four years. Having made this discovery, Fama and his colleagues buried it. The trouble with Mandelbrot’s insight was that it was too awkward to live with; it rendered the statistical tools of financial economics useless, since the modeling of abnormal distributions was a problem largely unsolved in mathematics. Paul Cootner, the efficient-market theorist and cofounder of Commodities Corporation, complained that “Mandelbrot, like Prime Minister Churchill before him, promises us not utopia but blood, sweat, toil and tears. If he is right, almost all of our statistical tools are obsolete— least squares, spectral analysis, workable maximum-likelihood solutions, all our established sample theory, closed distribution functions. Almost without exception, past econometric work is meaningless.”66 To prevent itself from toppling into this intellectual abyss, the economics profession kept its eyes trained the other way, especially since the mathematics of normal distributions was generating stunning breakthroughs. In 1973 a trio of economists produced a revolutionary method for valuing options, and a thrilling new financial industry was born. Mandelbrot’s objections were brushed off. “The normal distribution is a good working approximation,” Fama now contended.67 The crash of 1987 forced the economics profession to reexamine that assertion. In terms of the normal probability distribution, a plunge of the size that befell the S&P 500 futures contracts on October 19 had a probability of one in 10160—that is, a “1” with 160 zeroes after it. To put that probability into perspective, it meant that an event such as the crash would not be anticipated to occur even if the stock market were to remain open for twenty billion years, the upper end of the expected duration of the universe, or even if it were to be reopened for further sessions of twenty billion years following each of twenty successive big bangs. Mandelbrot, who had abandoned financial economics after the brush-off in the early 1970s, returned to the subject with a vengeance. His Soros-like thinking 106 MORE MONEY THAN GOD on “chaos theory,” which emphasized that small pieces of information could generate large price moves because of complex feedback loops, acquired a cult following among money managers. As well as challenging the statistical foundation of fi nancial economists’ thinking, Black Monday forced a reconsideration of their institutional assumptions. Efficient-market theory assumed investors always had the means to act: If they knew that a share of IBM was worth $90 rather than the prevailing price of $100, they would sell it short until the weight of their trading moved the price down by $10. This assuming away of institutional frictions involved a number of heroic leaps. You had to presume that the knowledgeable speculators could find enough IBM stocks to borrow in order to be able to sell them short. And you had to gloss over the fact that, in real life, the “knowledge” that IBM was worth $90 would be less than certain. Speculation always involved risk, and there was only so much risk that speculators could shoulder. They could not necessarily be counted upon to move prices to their effi cient level. Before the 1987 crash, these quibbles seemed insignificant. To be sure, the great mass of ordinary investors might lack the means and confi dence to act, but efficient-market theory pinned its hopes on the exceptional minority. It would take only a small handful of investors armed with information and capital to pounce on mispricings and correct them.68 But Black Monday demonstrated that sophisticated investors would not always succeed in correcting prices. In the chaos of the market meltdown, brokers’ phone lines were jammed with calls from panicking sellers; it was hard to get through and place an order. Any leveraged investor feared that his credit lines might be canceled; access to borrowing, assumed to be straightforward in efficient-market models, was in reality uncertain. And, most important, the sheer weight of selling made it too risky to go against the trend. When the whole world is selling, it doesn’t matter whether sophisticated hedge funds believe that prices have fallen too far. Buying is crazy. At a minimum, it seemed, the efficient-market hypothesis did not apply to moments of crisis. But the crash raised a further question too: If markets were efficient, why had the equity bubble inflated in the fi rst THE ALCHEMIST 107 place? Again, the answer seemed to lie partly in the institutional obstacles faced by speculators. In the summer of 1987, investors could see plainly that stocks were selling for higher multiples of corporate earnings than they had historically; but if the market was determined to value them that way, it would cost money to buck it. Hedge fund managers knew better than anyone that borrowing stocks to short is difficult and that the few skilled operators who do this have limited war chests. Because of these institutional realities, the overvaluation might well last. The effi cientmarket assumption of wise speculators pushing prices into line was, at a minimum, exaggerated. The third post-1987 assault on efficient-market theory was perhaps the closest to Soros’s own complaint about it. This line of attack went after the protagonist at the center of economists’ models, the impeccably rational figure known as Homo economicus. When investors could revise their valuation of corporate America by as much as a quarter in a single day, something other than rational analysis was in play; homo was not fully economicus. Economists were suddenly open to ideas that might explain the extent of the divergence. In 1988 Richard Thaler of the University of Chicago began to publish regular features in the Journal of Economic Perspectives that pointed out instances in which human choices appeared to violate economists’ expectations of rational beings. To Soros, who had obsessed about the limits to cognition since his student days in London, it was another victory. The triple attack on efficient-market theory—statistical, institutional, and psychological—was in some ways a vindication for the hedge-fund industry. It helped to explain how Michael Steinhardt’s block trading or Helmut Weymar’s commodity speculators could have done so well, and it showed that market practitioners had often been ahead of academic theorists. The realization that market efficiency is imperfect encouraged a wave of fi nance professors to launch their own hedge funds, and it persuaded sophisticated endowments to pour money into their coffers, triggering the industry’s headlong growth after 1987. But there was a darker side to this revolution in ideas. If markets were not always effi cient and 108 MORE MONEY THAN GOD rational, their effects on society might be pernicious too: Boom-bust sequences could distort and destabilize the economy, damaging ordinary workers and households. And if markets could be demons, surely fasttrading hedge funds must be demons on steroids? This suspicion, however exaggerated, haunted hedge funds repeatedly as they entered their golden era of expansion.