Steve Lescarbeau’s systems are the next best thing to a daily subscription to tomorrow’s Wall Street Journal. Lescarbeau invests in mutual funds. His goal is to hold them while they are going up and to be in a money market fund while they are going down. He times these asset transfers with such precision that he more than triples the average annual returns of the funds he invests in while sidestepping the bulk of their periodic downturns.
During the five years he has traded, Lescarbeau has realized an average annual compounded return of over 70 percent. As impressive as this may be, what is truly remarkable about his track record is that this high return has been achieved with extraordinary risk control: His worst equity decline from a month-end peak to a subsequent month-end low was a minuscule 3 percent. His consistency is also astounding: He has been profitable in 91 percent of all months, and his annual return has exceeded 50 percent every year.
For reasons he explains in the interview, Steve Lescarbeau is almost paranoid about revealing any details about his trading systems. He is also not interested in raising any money to manage. Why then did Lescarbeau even agree to do this interview? First, I assured Lescarbeau that he would see this chapter and have the opportunity to approve it before it was printed. Second—and this is just my guess—by his own account, Lescarbeau’s initial research direction was inspired by the Gil Blake interview in my book The New Market Wizards. Perhaps agreeing to this interview was a courtesy granted for having provided this indirect aid to his own career.
Lescarbeau doesn’t let up. Even though he has created some incredibly effective trading systems, he continues his research to find even better systems. His drive is not restricted merely to the markets; when he was in sales, he was consistently the top salesman in his company. Lescarbeau even approaches his leisure activities with intensity. He doesn’t merely go for a bicycle ride; he goes for a hundred-mile bicycle ride—at least he did until he blew out his knee by doing excessive repetitions, at too high a setting, on a weight-training machine.
Lescarbeau works alone at his home in a small rural town outside of Albany, New York. The interview was started and completed in Lescarbeau’s home office, a corner room with dark wood paneling, floor-to-ceiling bookcases, and windows overlooking his lawn. The middle portion of the interview was conducted over a buffet lunch at a local Italian restaurant, at which we were the only diners (due to the lateness of the hour for lunch, not the quality of the food).
How did you first get interested in the stock market?
I got involved in the financial services industry in 1983, working for a mutual fund company. To be perfectly candid, I switched into this field because I thought it was the place I could make the most amount of money as a sales kind of guy. I had a degree in chemistry from Boston University, which helped, but no training whatsoever on the financial side.
How do you go from chemistry to the sale of financial investments?
As a plug to BU, my degree in chemistry has been extremely helpful. I think that a physical science degree is as good as if not better than a financial degree because it trains you to be analytical. If there is anything I am really good at, it’s being a researcher. I’m not a particularly good trader. When I got out of school, I was sick and tired of studying, and I just wanted to make money. I got a job in sales using my chemistry background.
You didn’t try to get a job directly in chemistry?
No, chemists don’t make any money, but salesmen do.
Didn’t you figure that out in college?
Yes, when I was a senior [he laughs].
What were you selling?
Filtration systems to the pharmaceutical and electronic industries. It was very high-tech stuff. I was very good at selling. I was number one in sales for three years in a row.
How did you develop the talent for sales?
I’m just a willful person.
How did you go from selling filtration systems to selling financial investments?
When I won the salesman-of-the-year award, one of the prizes was a trip to La Costa, California. I remember driving down the Monterey Peninsula, seeing all these phenomenal houses, and thinking that I would never make the kind of money to be able to afford a similar house if I stayed with my firm. That’s when I decided to leave and do something where I could make more money. I looked into two fields—medical delivery and financial services—because the incomes were unlimited for a salesperson. In 1983, I took a job as a regional sales manager at a mutual fund company.
Did you have any experience in financial markets?
None whatsoever. In fact, when I won the salesman-of-the-year award at my previous job, they also gave me a hundred shares of stock. I didn’t even know what it was. I guess you can’t be much more ignorant of the market than that.
How did the new job work out?
I loved the job and did very well over the next few years. However, because of limitations that the company placed on me, I realized that if I wanted to take the next step, I would have to do something different.
I decided to become a stockbroker. I was interviewed and hired by Shearson Lehman Brothers. While I was there, I met Tim Holk, who was in managed futures—an area I knew absolutely nothing about. Tim had raised some retail money for Commodities Corporation. [At the time, Commodities Corporation had a group of in-house traders who managed the firm’s proprietary funds as well as outside investor funds. Two of the traders I interviewed in Market Wizards—Michael Marcus and Bruce Kovner—achieved their early success at Commodities Corporation.] One day, I went down with Tim to meet with some traders at Commodities Corporation. After that meeting, I told Tim, “Screw the retail money; let’s go after institutional money.”
I cold-called Eastman Kodak. That initial call ultimately led to their opening a $50 million account—the largest investment ever in managed futures. They eventually upped their investment to $250 million.
What did you know about managed futures?
Nothing, but I did know enough to realize that it was a waste of time to call individuals and that it made a lot more sense to call institutions.
Then how did you sell Kodak on the product?
I told them, “Here is an investment that has no correlation with the stock market and has been compounding at about 30 percent per year.” The Kodak account started me toward financial independence.
After the Kodak sale you must have thought: “This is really easy!”
I expected the money to pour in.
Were you successful at opening other accounts?
We tried to open other institutional accounts, but nothing happened. We basically had one account. No other institutions stepped up the plate.
So, on your first sales call, you landed a $50 million account, and then you never made another sale again.
It’s hard to believe, but it’s the honest-to-God truth. The Kodak account was my only source of income.
Still, given the size of the account, you had to be doing pretty well.
We were making a lot of money off the account, but the problem was that it was a typical managed futures account—up-and-down, up-and-down—it was sickening to watch. The traders would make money, and then they would give it all back. I was concerned about losing the account because of all the volatility. So I started looking around for something else to do.
Sometime around 1993, I became interested in a stock market newsletter written by a guy in Texas. He put out recommendations on mutual sector funds and had a good track record. I called him up and suggested that we do a fund. He agreed, and the fund was launched in September 1993. He was the trader, and I raised the money.
Had he traded before this fund was formed?
No, he was just a newsletter writer. This was his first experience with trading real money.
Hadn’t the idea of trading occurred to him before?
I think he was somewhat conservative. He had a good position at IBM, which he was reluctant to give up. He had been writing the newsletter on the side. I convinced him to leave IBM. In the first ten months I raised approximately $10 million. After the first year, he was up about 9 percent with a lot of volatility. I realized that this was not for me—the equity swings were just too volatile relative to the mediocre returns being realized.
By late 1994, I had become completely disenchanted. At the same time, I had begun doing my own research on mutual fund timing and thought I could do better. The trading manager and I agreed to split up. He kept the individual managed accounts, and I took over management of the partnership account.
You said you began doing research. Had you developed a trading method by the time you took over as the fund manager?
No, I didn’t have enough confidence in my research. I knew I wasn’t quite there yet.
Then what was your plan for trading the fund?
I didn’t have any great plan. I just knew that what we were doing wasn’t working. I had enough confidence in my abilities to believe that I could come up with something better.
So your trading method was still a work in progress at the time you took over the trading responsibilities.
Yes.
Did you consider delaying the split with your partner until you had developed your own trading strategy?
No, I knew I would come up with something. There was absolutely no doubt in my mind. I had never failed to succeed at anything that I put my mind to, and this was no different.
Still, you had never traded successfully.
The characteristics of being a good trader or investor are very similar to the traits needed for success in general. I think it would be very difficult to find someone who was not successful at what he was currently doing, put him in a trading position, and make him successful. I don’t think that is going to happen. The same qualities that make you a successful person in whatever you’re doing are going to make you successful in trading. You have to be very decisive, extremely disciplined, relatively smart, and above all, totally independent. I have those traits. Therefore, when I decided to become a money manager, it didn’t require a leap of faith to believe that I would be successful.
Since you hadn’t fully developed an alternative trading method when you began trading the fund, how did you make your trading decisions?
It was a joke. I didn’t know what I was doing. I did what everyone else does. I looked at a chart, and if it looked strong, I bought it.
How long did this go on?
For most of the first quarter of 1995. I was lucky to finish the quarter up a few percent. By March 1995, I had systematized my approach and felt confident that I had come up with something that would work. I implemented an embryonic version of what I do now.
That implies that you have changed your system very substantially since you first started. Were these changes a consequence of ongoing research, or were they triggered by your trading experiences?
I had several important events in my track record that caused me to change significantly from what I had started out doing. I had a very good first year. I finished 1995 with a 58 percent gain and no losing months from the time I adopted my systematic approach.
In January 1996, however, I found myself down about 5 percent by midmonth. That may not sound like much to most people, but to me it was a huge amount. Because of that drawdown, I spent an enormous amount of time doing research on the computer and ended up making very significant changes to my methodology.
Everything went along well until late 1996, when my trading results went relatively flat. For the fourth quarter of 1996 and the first quarter of 1997 combined, I was up only a little over 1 percent. This was definitely not what I was looking for. I realized that I had to make some changes. During that period, I was on the computer all day, almost every day. In March 1997, I implemented some very significant changes to my systems. Since then, the performance has been quite good.
Although my systems have been unchanged since then, over time I realized that I could combine my systems with my experience. Now my systems tell me what to do, but there is also judgment involved. This judgment doesn’t necessarily make me more money, but it does reduce my equity swings. I usually err on the side of caution if I lack conviction on a trade.
Can you give me an example of how you use judgment?
There is never any judgment whether to buy or sell; the only judgment is how much to buy or sell. The problem with system trading is that it doesn’t tell you how to trade your portfolio; it just gives you buy and sell signals. I trade several different systems, each based primarily on one indicator. I might have a system that has been performing extremely well give me a buy signal, but I may decide to take a smaller-than-normal position because other systems are giving me contradictory indications.
What is another example of judgment causing you to deviate from the strict signals of your system?
Let’s say the market has been trending up for a while, my systems are long, and I’m making a lot of money. Although everything may look great, I get uncomfortable when my equity line starts going above its long-term uptrend. I am likely to cut back my position size, anticipating that the equity line will come back to the long-term trend. Judgment like that saves me money rather than makes me money.
Judgment is also important in deciding which systems I use. Interestingly, the systems I used a few years ago are not doing particularly well anymore. Somehow I’ve been successful in changing so that I’m usually trading the best systems. I can’t tell you how I’ve managed to do it. I guess it must be intuition.
If you stop trading a system because it shows some deterioration, do you sometimes go back to using it several years later?
No, because I replace inferior systems with superior systems. There is a reason why I replace trading systems, and the reason is that I have a better idea. I still keep an eye on old trading systems, but I won’t use them.
Doesn’t it sometimes happen that a discarded system begins performing better than a system you are currently using?
It probably will happen at some point, but it hasn’t happened yet.
Do you trade individual stocks?
No, although it is very likely that my systems would also work on stocks. In fact, that’s my next research project.
So, what is your trading vehicle?
Mutual funds, but I’m not a market timer. Let’s discriminate between a market timer and what I consider myself—a market reactor. A market timer says, “The market is too risky here. I think the Dow is going down to 8,000 during the next three months.” They have a view about what is going to happen. They prognosticate the market. I do not attempt to prognosticate the market. I react to what happens in the market.
Your actions, however, will be the same as a market timer. You will switch back and forth between a mutual fund and cash, based on the timing signals of your systems. Isn’t that the same thing as a market timer?
The actions may be the same as a market timer, but the thinking is completely different. I make no predictions. I have absolutely no idea what is going to happen [he laughs].
Why are you laughing?
I’m laughing about the people who do make predictions about the stock market. They don’t know. Nobody knows. I don’t think anybody has any idea what is going to happen in the stock market.
Does your own performance depend on the mutual funds you choose to trade?
Only to a very limited extent.
Do you trade mutual funds that represent the broader market?
I have tested my systems on marketwide funds, and they work well. But I usually prefer to go after a smaller area of the market. I’m looking for funds that would have a bit more zing on the upside, and the S&P is not zing. Therefore, I’m much more likely to trade something like a technology fund than a broadly diversified fund.
I don’t expect you to reveal the systems you are currently using. However, are there systems that you developed in the past and that worked for a while, but are worthless to you now? At least that would provide an illustration of what a system idea that worked for a while looks like.
I can give you an example of something that might not be too distant from what I used to do by describing my perception of Gil Blake’s system. [Blake was a trader interviewed in The New Market Wizards.] Gil’s approach was to follow different sectors, and if on a given day, a sector had both above-average volatility and above-average return, it would be considered a buy signal for that sector fund, or a “green light,” to use his terminology. Then he would hold the long position in that fund until his sell condition was met, which might have been a down day, or the passage of a specific number of days following the buy signal, or some other liquidation condition.
That system provides a good example of the kind of thinking that I do. There is no reason why you couldn’t implement that type of system today. Although it wouldn’t do remotely as well as what I am using now, it would probably still work to some degree.
Did you have that type of idea before you read the Gil Blake chapter?
No. Reading the Gil Blake chapter was a key turning point for me. Although what I do now has nothing to do with what Gil was doing then, it at least helped me get to the point where I could start doing research on the computer.
Did you ever talk to Gil Blake?
Yes, I called him when I first started managing money and said, “My name is Steve Lescarbeau, and I just wanted to tell you that you’re the reason I’m in this business.” He groaned, “Oh God.”
Yes, I could imagine how many times he had heard that line. If you had not read his chapter, would you have ended up in this business?
I don’t know; it was that important.
Does your original trading system—the one inspired by Gil Blake’s interview—still work?
It works, but it has degraded a lot.
Do you think this might be a temporary phase and that in the future it might start working very well again?
I doubt it.
Can you see yourself ever using it again?
No.
If you don’t expect to ever use it again, and it’s not related to what you are doing now, is there any reason why you couldn’t talk about it more specifically?
Well, you never know [he lets out a long laugh].
Are you still in the process of trying to improve what you are doing?
Absolutely. I’m trying to, but I don’t know if I’ll be able to. It’s hard to improve on 60 percent a year, * but I’ll be happy to maintain it. I’m constantly concerned that it is going to go away. In fact, I know it will. If you come back a year from now, I’ll probably be doing something different. I’m sure what I’m doing now won’t work as well as it has up until this point.
You are implying that systems have a life span.
There is absolutely no doubt about it. There is no way anyone could convince me otherwise. Systems definitely have a life span.
Why do you think that is?
I think it’s because eventually enough people figure it out. When too many people jump on the bandwagon, the market takes it away. That’s why I would be very skeptical about anyone being able to buy a trading system that worked—that is, a system that made money with an acceptable level of risk.
If you develop a system that you have thoroughly tested and truly believe works, don’t tell anyone about it. Use it, because it’s going to go away at some point in time. Understand that it won’t last forever, and work on coming up with something different for when that happens.
I’m always concerned about people figuring out what I do, because I know if that happens, it’s going to stop working. For example, the “January effect” is gone. [The January effect is the tendency for small capitalization stocks to outperform large capitalization stocks during January—a pattern that until 1993 had repeated in over 90 percent of all years since the mid-1920s. Then the pattern failed six years in a row. Lescarbeau is implying, quite plausibly, that the January effect’s increasing publicity triggered its own demise.]
If too many people are using the same system, what mechanism in the marketplace causes the system to self-destruct?
I can’t answer that question. It could just be a matter of too many people on the same side of the trade at the same time. Everything I have experienced tells me that systems have a life span, and not a terribly long life span.
That speaks to the death of systems; what about the birth of systems? Will systems start working at some point in time, say 1994, and then stop working a few years later? Or if you tested the systems you are currently using over the past twenty or thirty years, would you find that they worked over the entire time span, but it’s just a matter of your not finding them until more recently?
Usually when I discover a system, it’s been working all along. Having said that, though, I find that the systems that have done the best in the most recent past also tend to do the best in the immediate future. Therefore I tend to lean on the systems that have done the best very recently.
You say that systems have a limited life span, but by your own admission, the systems you are using have worked for over twenty years. Why couldn’t they work for another twenty years?
I understand where you are going with that question, but I don’t agree with the conclusion. I don’t buy it because there is just a lot more money pouring into the markets. The best example is the commodity markets. When we sold the managed futures account to Kodak, the traders managing the account had systems with great track records; these systems had been averaging 40 percent for fifteen years. They said there was no way that these systems would stop working. Well, they did. They stopped working because too many people started using similar systems.
Another classic example is O’Shaughnessy. His book What Works on Wall Street was terrific; it was well written and well researched. The performance of his funds, however, has been less than stellar.
What do you consider “less than stellar”?
[At this point, Lescarbeau looks up the performance of O’Shaughnessy’s funds on his computer screen. He checks two of the funds and finds that they are up 43 percent and 46 percent. Although this doesn’t sound too disastrous, during the same time period (late 1996 to mid-1999), the S&P 500 was up 89 percent. So, these funds made only about half as much as the S&P 500, which is representative of the benchmark they were designed to beat.] Great book. He tested his strategies all the way back to the early 1950s, but they don’t work.
So, even though his strategies worked for over forty years at the time the book was published, they have stopped working in recent years.
You know what? Had he not published his book, they might well have continued to work. He should have just managed money and not published his book; of course, if he hadn’t published the book, he probably wouldn’t have raised any money.
Your premise is that his strategies stopped working because too many people were following the same ideas.
Exactly. The most important message I can give anyone who reads your book is that if you have a great idea, don’t talk about it.
Some people I have interviewed say, “I could publish my system in the Wall Street Journal and it wouldn’t make a difference.” I take it that you don’t agree.
I’ve read statements like that, and I couldn’t disagree more.
You feel that if you described your system in The Wall Street Journal, it would stop working.
It would be over. Tomorrow [he laughs]!
At one point, you had investors, but you no longer do. What happened?
I had investors from 1995 through 1997. I did very well for them—I was up 58 percent in 1995, 50 percent in 1996, and 60 percent in 1997. By the end of 1997, I was managing about $35 million. It became very difficult to use my style of investment, which involves switching money in and out of mutual funds, because mutual funds don’t like it if you trade more than four times a year.
But you trade more than four times a year now.
I trade a lot less money, and I have it spread out over more than twenty mutual funds.
So you stopped managing money for logistical reasons?
That and because investors can be such a pain.
What could your investors possibly have complained about? You made over 50 percent every year with hardly any losing months.
You can’t even imagine the stuff they complained about. They complained that I didn’t make enough money if I wasn’t up at least 4 percent for the month. They complained that I made too much money because they had to pay taxes on the profits.
I can’t believe it; you actually had someone complain that you made too much money!
I told him that I could lose money; then he wouldn’t have to pay any taxes. I asked him if he would prefer that.
Some investors didn’t trust me. Because the results were so good, they thought I was making up the numbers and had absconded with their money. They would call my accountant every month to ask if the money was really in the account.
If the market was up a lot on the day, they would call up and ask, “Are we in the market?” That would drive me crazy. If the market was down a lot, they would call up and ask, “Are we out of the market?” Of course, they always expected me to be on the right side of the market.
How much of your decision to get out of money management was due to the headaches given to you by mutual funds and how much was due to the headaches given to you by your investors?
Split equally! [He laughs loudly.] I think I used the headache I was getting from the funds as the excuse to give investors their money back. I did feel badly for those investors who had been with me from the beginning and had never opened their mouths.
Didn’t the friends who were your original investors and hadn’t bothered you try to talk you into not returning their money?
They did, but my problem was how to differentiate between this friend and that friend? Where do I draw the line? Therefore, I had to do it across the board.
Did you lose any friendships as a result?
No, although they still ask me to reconsider whenever we get together for a poker game.
It is interesting that so many of the traders I have interviewed are poker players.
I love playing poker.
I assume the stakes you are playing at are not terribly meaningful relative to the amount of money you are trading. You could stay in every hand, and it wouldn’t make any difference to you.
It’s pretty hard to get concerned about losing $200 when you’ve just lost $100,000, but I never let my income level interfere with the way I play. I play to win. If a hand is not a good bet, I get out.
Do you ever break your trading rules?
Only on the side of caution. I might take partial profits on a position, or not go fully long on a buy signal, but I will never hold after a sell signal.
Were you that disciplined from the very beginning?
Yes, because prior to that, I did all my screwing up in futures. I made every possible mistake you could make. I don’t even have to go over them because they are all classic mistakes.
How long did you trade futures?
[He searches his memory for a while, as if trying to retrieve an experience from the distant reaches of his mind.] For about three years.
Were you a net loser?
Oh, big-time! I made money investing with other futures managers, but trading for my own account, I turned a $125,000 account into $50,000. I did everything wrong.
Were there any particularly painful trades during that period?
Too numerous to count.
What stands out?
I developed a currency trading system. I bought this computer software program that allowed you to optimize trading systems [to finetune the indicator values in a system so as to maximize the performance results for the tested price data]. Like any stupid trader, I optimized it completely. [He adjusted the system indicator values so that they best fit the past price data.] Of course, the results looked spectacular. [Because by optimizing, he was using hindsight to define and test the system. The problem is that the results will be very misleading when applied to unseen price data—namely, future price data.] I knew better, but I didn’t think it applied to me.
In a span of two weeks, I lost about 50 percent of the money in my trading account. I started veering from the system, and every time I did, it was the absolute wrong time to do it. It was a nightmare. I realized I wasn’t cut out to trade futures.
This sounds like the only thing you ever did where you failed. With everything else you kept at it until you succeeded. Why did you give up here?
Because I realized futures were a losing game. The commissions and slippage [the difference between the screen price and the actual trade execution price] placed the odds too much against you. If you have only a 50 percent chance of being right when you buy or sell, and you pay commissions and incur slippage costs, you have to lose over the long run.
But that 50 percent assumption presupposes that you don’t have any edge in the market. Couldn’t you have found patterns that had some reliability and gave you an edge similar to what you did in the stock market?
I couldn’t do it. I couldn’t find any patterns that worked.
Are you able to take any vacations?
Yes, as long as I have access to my computer. I own a vacation home on a lake in New Hampshire.
What if you wanted to go away and hike in the Swiss Alps, or for that matter even take a full-day hike in the White Mountains?
For five years, I have been available at 3:45 P.M. every day without exception. I have never taken a day off. The problem with taking a day off is that it will probably be the day you shouldn’t have taken off.
What happened when you had your knee surgery? [Lescarbeau and I had compared notes on personal sports injuries on our drive back from the restaurant.]
I had outpatient surgery with general anesthesia. I returned home at around 11 A.M., very groggy, and went straight to bed. My wife was supposed to wake me at 3:30, but out of compassion, she decided to let me sleep. At 3:45, I woke up with a start. I was in the bedroom, which is on the other side of the house. I jumped out of bed and with excruciating pain hobbled down to my office. I looked at the screen, and based on what I saw, I sold half my portfolio.
An hour later, I returned to the office and looked at the screen again. I realized that I had totally screwed up. I couldn’t figure out why I had sold anything. I had completely misread the information. As it turned out, the next day the market tanked. It was utter luck.
What percent of the time are you in the market?
About 50 to 55 percent of the time.
Do you use leverage?
Selectively. On average, I’m less than fully invested, even counting only those days when I am in the market. Occasionally, if conditions are right, I use leverage. But I have never been leveraged more that 140 percent of my capital—that’s the limit of my comfort level. I have never lost money on a trade that I was leveraged on.
Do you ever go net short?
Ninety percent of my success is due to not doing things that are stupid. I don’t sell winners; I don’t hold losers; I don’t get emotionally involved. I do things where the odds are in my favor. Shorting stocks is dumb because the odds are stacked against you. The stock market has been rising by over 10 percent a year for many decades. Why would you want to go against that trend?
Any advice for novice traders?
Don’t confuse activity with accomplishment. I think one mistake novice traders make is that they begin trading before they have any real idea what they are doing. They are active, but they are not accomplishing anything. I hardly spend any time trading. Over 99 percent of my time is spent on the computer, doing research.
Although Lescarbeau refused to reveal any details about his own trading systems, he provides some important insights into the traits of a successful trader. One characteristic that I have repeatedly noticed in winning traders—and that is probably true of winners in any field—is that they are extremely confident. Perhaps no other trader I have interviewed has exemplified this quality better than Lescarbeau. He exudes confidence. Consider, for example, his description of the certainty that he would succeed as a money manager before he had even developed a methodology. (Lescarbeau’s decision to assume trading responsibility before he had developed a trading method is not being held up as model of laudable behavior—on the contrary, for most people it would represent a reckless course of action—but only as an illustration of his sense of confidence.)
An honest assessment of your own confidence level may be the best indicator of your potential for success. If you are confident that you will succeed in the markets—not to be confused with wanting to be confident—then the odds are good that you will. If you are uncertain, then tread very gingerly with your risk capital. Confidence cannot be manufactured or wished into existence. Either you have it or you don’t. Can’t confidence be acquired? Sure, sometimes hard work—another trait of winning traders—can lead to proficiency, which can lead to confidence. But even then, until you are truly confident, proceed with great caution in the markets.
Another trait I have noticed among the Market Wizards is that they approach trading and sometimes other endeavors with an intensity bordering on obsession. Lescarbeau is a perfect example. He never misses a day—even surgery didn’t prevent him from checking the market. Whenever the performance of his systems failed to meet his extraordinarily high standards, even though this meant nothing worse than a break-even quarter or two, he worked incessantly to develop better systems. Even his recreational activities—for example, bicycling and weight training—reflect an obsessive streak.
Is there any single trait that is shared by all great traders? Yes, discipline. Lescarbeau’s unfailing sense of discipline is clear in all his actions. He has never decided to hold a position once he gets a sell signal. If his system tells him to liquidate, he’s out—no questions, no second-guessing, no qualifications. He never thinks “I’ll just give it one more day” or “I’ll get out if it goes down another 2 points.” For Lescarbeau, discipline also demands being there every day to check the system signals and enter the orders. Every day means every day; no minivacations, no days off—not even after surgery. The essence of discipline is that there are no exceptions.
Many people are attracted to the markets because they think it is an easy way to make a lot of money. Ironically, hard work is one of the key common denominators I have noted among the traders I have interviewed. Even though Lescarbeau has already developed trading systems that are incredible—his trading system results are by far the best I have ever seen and beyond anything I even thought possible—he continues his research without abatement. He doesn’t relax even though what he is using is working and has been working for years, but instead he plows ahead daily, as if what he is using will cease to work tomorrow.
Risk control means longevity. Some traders achieve high returns for many years, but with large equity retracements as a byproduct of their methodology. Although these traders can attain great track records, they often skate near the edge—and in doing so, they are always in danger of falling. A trader like Lescarbeau, who keeps his losses very low, has a much higher probability of long-term success.
Update on Steve Lescarbeau
Although Lescarbeau has fared quite well during the bear market—his family partnership was up 39 percent from April 2000 through September 2002—more than half the gains were realized before September 2000, and as indicated in the following update, Lescarbeau has lost confidence in the efficacy of his systems.
What happened in February 2001? [Lescarbeau’s account was down 5 percent that month—a single-month decline that exceeded his previous worst peak-to-valley equity drawdown.]
The problem actually began in November 2000 when I lost over 3 percent, which at the time was the worst month I ever had. Although December approximately recovered the entire November loss and the system was profitable again in January, the November loss was an early warning sign that something was potentially wrong. Then came the February loss, and I knew I was dealing with something I had never seen before. It was a period when what I had been doing for many years simply didn’t work.
How much time do you need to decide that a system is not working?
Well, there is no easy answer to that question. The system I was using at the time had worked for several years in real time and for decades in backtesting. So, maybe I was bit too slow in reacting.
When did you switch systems?
I basically stayed out of the market during April 2001. I really didn’t know what I was going to do because I hadn’t come up with anything. I just knew I couldn’t continue to use the same system anymore because it had stopped working. By May, I had developed a modified system that was workable, but not one I felt really good about. By summer I came up with the system I am using now.
What would have happened if you had continued to use your previous system after March 2001?
It would have been a disaster. I would have been down 25 to 30 percent.
I know you have switched to what you consider improved systems several times in the past. Would some of these older systems have worked better?
They would have done even worse!
How is your current system different from the one you stopped using after March 2001?
Essentially, the system I use now makes it much more difficult to get a buy signal and much easier to get a liquidation signal. So I am making far fewer trades, and when I am in the market, it takes a smaller adverse price move to get me out. For example, I have not had a buy signal in nearly four months. With my old trading system, I would have been trading through this decline and getting killed.
If, on balance, your system tends to keep you out of the market during periods of declining prices, it seems like you should be able to significantly improve your results by going short during those times instead of going into cash. Why don’t you use your liquidation signals as short signals?
The truth is that I have never been able to develop a system that could make money consistently—and consistently is the key word—on the short side.
Why couldn’t you simply reverse to short on a liquidation signal instead of going neutral?
If I could go short the funds I buy, that would be great, but of course that’s impossible. If I want to go short, I have to either buy a short stock index fund or directly go short stock indexes. The trouble is that my systems work tremendously better on the types of mutual funds I buy—aggressive growth funds—than on stock indexes, for which their performance is only mediocre.
After our original interview, you decided to accept investor money again. Then in the second quarter of 2001, you once again told investors that you were returning their money. What was the reason for this decision?
Because I had done so poorly, and I had completely lost confidence that the system I was using would continue to make any money. Moreover, not only did I lose confidence in my system, but I had no idea what I was going to do to fix it. It was just the low point in my career.
Although the system I subsequently developed kept me from losing money, in truth, my trading approach hasn’t worked since the fall of 2000. For the past six months, I’ve hardly traded at all. I believe the drastic deterioration of the types of systems I use is a direct consequence of the Internet-related surge in hype and speculative activity, which has made the market much more random. There has been a marked decrease in market follow-through. Trends that used to last a week, last two days; trends that used to last two days, last three hours. I’m not bullish on my approach until we wipe out the excess, which I think will take years. Virtually all primary bull markets have been followed by bear markets and then a long period of malaise. This one will be no different.
I take it then that you don’t anticipate any significant recovery in the stock market for the foreseeable future, despite the sharp price slide we’ve seen.
If you study the long-term history of stock prices you repeatedly see that it takes a very long time for markets to recover after major tops. As Schiller points out in his book Irrational Exuberance, after each of the three major peaks in the twentieth century—1901, 1929, and 1966—the stock market took roughly twenty years or so to get back to even [in inflation-adjusted terms]. Since the 2000 peak occurred at even significantly higher valuation levels than any previous market top, including 1929, it wouldn’t be surprising if it took another twenty years to get back to that level [in inflation-adjusted terms]. The implication is that the market bottom probably won’t come for another few years, and if it’s like all other previous major bottoms, it won’t occur until we are at extreme low levels.
How far down could you see the market going?
For me the magic number is five: somewhere around 500 in the S&P 500, somewhere around 5,000 in the Dow, somewhere around 500 in the Nasdaq 100, and sometime in about five years [2007].
That sounds almost mystical.
Well that’s just my guess. Of course, I won’t let this projection interrupt my trading. The next time I get a buy signal, I will buy.
What do you think is the biggest misconception people currently have about the market?
The biggest misunderstanding that the average investor has is the inability to comprehend the concept of years. People who know I trade the markets are constantly asking me where I think the bottom is going to be. “Are we almost there yet?” they ask. When I tell them I think the bottom is at least several years away, they look at me like I have three heads.