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OUR CONFEDERACY OF DUNCES

            The Darwin Award confers mock recognition on individuals killed by their own stupidity, thereby improving the gene pool by removing themselves from it. If there existed such an award at the national level, the U.S. of today would be ...

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CanWeReallyUnderstandMatter

BY EUGENE LINDEN


Monday, Apr. 16, 1990
Few tasks are more daunting than standing in the path of a charging theoretical physicist who is hell-bent on getting funding for the next particle accelerator. As practitioners of the hardest of the hard sciences, physicists do little to discourage their aura of intellectual supremacy, particularly when suggesting to Congress that a grand synthesis of all the forces of nature is at hand if the Government will only cough up a few billion dollars more. But what if this confidence is misplaced? What if the barriers to knowledge are higher than many physicists like to admit?

For much of this century, scientists have known that the comfortable solidity of things begins to break down at the subatomic level. Like the Hindu veil of Maya, the palette from which nature paints atoms proves illusory when approached. From afar, this world appears neatly separated into waves and particles, but close scrutiny reveals indescribable objects that have characteristics of both.

Physicists have prospered in this quirky realm, but neither physics nor the rest of science has fully digested its implications. Inside the atom is a world of perpetual uncertainty in which particle behavior can be expressed only as a set of probabilities, and reality exists only in the eyes of the observer. Though the recognition of this uncertainty grew in part out of Albert Einstein's work, the idea bothered him immensely. "God does not play dice with the universe," he remarked.

The set of mathematical tools developed to explore the subatomic world is called quantum mechanics. The theory works amazingly well in predicting the behavior of quarks, leptons and the like, but it defies common sense, and its equations imply the existence of phenomena that seem impossible. For instance, under special circumstances, quantum theory predicts that a change in an object in one place can instantly produce a change in a related object somewhere else -- even on the other side of the universe.

Over the years, this seeming paradox has been stated in various ways, but its most familiar form involves the behavior of photons, the basic units of light. When two photons are emitted by a particular light source and given a certain polarization (which can be thought of as a type of orientation), quantum theory holds that the two photons will always share that orientation. But what if an observer altered the polarization of one photon once it was in flight? In theory, that event would also instantaneously change the polarization of the other photon, even if it was light-years away. The very idea violates ordinary logic and strains the traditional laws of physics.

The two-photon puzzle was nothing more than a matter of speculation until 1964, when an Irish theoretical physicist named John Stewart Bell restated the problem as a simple mathematical proposition. A young physicist named John Clauser came upon Bell's theorem and realized that it opened the door to testing the two-photon problem in an experiment. Like Einstein, Clauser was bothered by the seemingly absurd implications of quantum mechanics. Says Clauser, now a research physicist at the University of California, Berkeley: "I had an opportunity to devise a test and see whether nature would choose quantum mechanics or reality as we know it." In his experiment, Clauser, assisted by Stuart Freedman, found a way of firing photons in opposite directions and selectively changing their polarization.

The outcome was clear: a change in one photon did alter the polarization of the other. In other words, nature chose quantum mechanics, showing that the two related photons could not be considered separate objects, but rather remained connected in some mysterious way. This experiment, argues physicist Henry Stapp of Lawrence Berkeley Laboratories, imposes new limits on what can be established about the nature of matter by proving that experiments can be influenced by events elsewhere in the universe.

Clauser's work pointed out once again that the rules of quantum mechanics do not mesh well with the laws of Newton and Einstein. But most physicists do not see the apparent disparity to be a major practical problem. Classical laws work perfectly well in explaining phenomena in the visible world -- the motion of a planet or the trajectory of a curveball -- and quantum theory does just as well when restricted to describing subatomic events like the flight of an electron.

Yet a small band of physicists, including Clauser and Stapp, are disturbed by their profession's priorities, believing that the anomalies of quantum theory deserve much more investigation. Instead of chasing ever smaller particles with ever larger accelerators, some of these critics assert, physics should be moving in the opposite direction. Specifically, science needs to find out whether the elusiveness of the quantum world applies to objects larger than subatomic particles.

No one worries about the relevance of quantum mechanics to the momentum of a charging elephant. But there are events on the border between the visible and the invisible in which quantum effects could conceivably come into play. Possible examples: biochemical reactions and the firing of neurons in the brain. Stapp, Clauser and others believe that a better understanding of how quantum theory applies to atoms and molecules might help in everything from artificial-intelligence research to building improved gyroscopes. For now, though, this boundary area is a theoretical no-man's-land. Certainly physicists are a lot further from understanding how the world works than some would have Congress believe.

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Short Take

I’ve just read Black Edge, by Sheelah Kolhatkar, which is about the huge insider trading scam that characterized Steve Cohen’s SAC Capital at the height of its power. I’m going to offer the thoughts it prompted in two parts. The first will delve into the trade itself, and the second will explore the fallout from this insider trading scandal and subsequent events in the market.

Part One:

A good part of Black Edge focuses on one specific instance of insider trading at SAC Capital: Mathew Martoma’s quest for advance knowledge of the results of trials on the efficacy of Elan Pharmaceutical’s experimental drug to halt Alzheimer’s disease. The drug, bapineuzumab, was designed to attack the amyloid plaques that Elan’s scientists viewed as the cause of cognitive decline. In his quest for “black edge” (illegal inside information) Martoma and his compatriots compromised the integrity of the procedures for drug trials and ruined the life and reputation of a distinguished scientist.  Even that wasn’t enough for them. SAC also had access to vast amounts of biotech expertise, both from PhDs on their payroll, and the expert networks they paid handsomely to give them access to researchers with direct access to the studies and trials.

 

In the short run, this inside information paid off for SAC as Martoma’s advance knowledge of the results allowed the hedge fund to reverse a billion dollar position and make a profit of over $180 million versus certain losses of hundreds of millions had they not gotten advance information on a disappointing field trial. In the long run, while Steve Cohen skated, the insider cases led to $1.8 billion in fines, the dissolution of SAC, and jail time for Martoma.

 

In retrospect, it was all so stupid. SAC could have come to the conclusion that Elan’s drug was not going to work without resorting to anything illegal.

 

Instead of deploying all this massive intellectual firepower on getting advance word on the results of the trials, the analysts might have started by asking how solid were the assumptions on which the therapy was based: namely, whether attacking the plaques would halt or reverse the progress of the disease.

 

Even in 2008 and 2009, there were a number of researchers at distinguished universities who questioned that basic assumption. The alternate theory was that the plaques were not the cause of the disease, but rather an analogue of scabbing, the result of the body’s attempt to protect the brain from infection.

 

 In subsequent years, this alternate view has gained some traction, with some now arguing that Alzheimer’s is akin to an autoimmune disease in the sense that as the environment in developed countries has become more antiseptic, protective devices in the brain have turned on the brain itself as the infections they evolved to fight have disappeared. In any events a drumbeat of failed trials with drugs attacking amyloids has discredited this approach. As Tara Spires-Jones, of Edinburgh University’s Centre for Cognitive and Neural Systems put it in an interview with Britain’s Independent, “Most of the trials have been based on the assumption that amyloid is important in causing Alzherimer’s diseas, as opposed to something that happens alongside it. That assumption, I think, is probably wrong…”

 

Even in 2007, SAC’s analysts should have known that many attempts to fight Alzheimer’s by fighting the formation of plaques had failed. Given all the time the fund spent analyzing the drug and trials it must occurred to someone to ask whether Elan was barking up the wrong tree. Maybe someone there did just that, but there’s no indication that the decision makers ever questioned the assumptions upon which the drug was built.

 

Maybe that wouldn’t have mattered. SAC wanted certainty. Clearly, detailed advance knowledge of the results of a field trial is more compelling than a dissenting theory on the nature of the disease. Had SAC questioned the assumptions of the study, they never would have amassed a position in Elan, and they probably wouldn’t have had sufficient certainty to short the stock prior to the results being announced.

 

What can be drawn from this? There are implications about the pressures of the markets – SAC employees felt that had to cheat to maintain performance – but there are also implications about the culture of world of investing.  Alzheimer’s is a horrifying disease, but the book makes a strong case that neither Cohen, nor anyone else at SAC, gave a rat’s ass whether the drug worked or not; they only cared about knowing the results before anyone else and about how other traders would view the data when it came out.  The same probably applied to every other fund playing Elan.

 

It isn’t news that the markets are amoral, but this amorality has real world consequences. The punishment the market meted out to Elan (and other companies with failed trials) makes all but the largest companies risk averse about investing in therapies for difficult diseases. There is a short-term logic to this from an investor’s point of view, but, increasingly, the market sets research priorities, and the market’s priorities – controlling costs and maximizing short-term profits – may not serve the needs of society. Researchers know that breakthroughs often come from learning from failed previous attempts.  So where will breakthroughs come from as fewer and fewer companies risk failure?

 

Part Two:

 

Further thoughts on Black Edge by Sheelah Kolhatkar

The insider trading scandal at SAC confirmed a widely held suspicion among ordinary investors that Wall Street is a rigged game where powerful players can cheat with impunity.  Regardless of the truth of that suspicion, the widely held perception that this is the case has had its own reverberations. In a delicious irony, one of the derivative effects of the market crash and subsequent insider trading scandals has been to make more likely a future in which black edge is less useful.

 

Bear with me.

 

What happened with Elan revealed a contradiction at the heart of the markets. SAC was driven to seeking black edge by the ruthless competition of the markets. In the minds of their analysts and portfolio managers, access to publicly available information wasn’t enough because competing funds had their own PhDs pouring over the same information. Moreover, competing funds also had access to the same expert networks (which might be viewed as “grey edge”) as did SAC.

 

In such a situation, we’d expect that different analysts would take different perspectives on the prospects of the drug and the trials. I would have expected that at least some analysts would question whether the assumptions behind the drug were correct. The market says that wasn’t the case. Rather the hedge fund world was massively longs before the release of the trial results, and Elan’s subsequent 66% price drop suggests that the herd mentality applied on the way down too.

 

So market efficiency drove SAC and some others to seek black edge, while the subsequent drop exposed a herd mentality and deep inefficiency that made the market anything but a black box that continuously adjusts prices for all information.

 

The result for the markets is analogous to the evolutionary theory of punctuated equilibrium: markets will proceed smoothly until some event produces rapid change. Because, as the crash of 2008 demonstrated, the big price-change inducing event can come from any number of directions inside or outside the economy, many investors are giving up on analysis of individual stocks and moving to passive investment funds and ETFs. The size of this shift is staggering. The amount of managed money in passive strategies has risen from an estimated 6% in 2006 to as much as 40% today (these figures vary depending on definitions of what a constitutes passive strategy).

 

That latter figure may be larger given the relationship between value investing and money moved by algorithms and quantitative strategies.

 

Quantitative types try to beat their peers by focusing on changes in pricing or volatility, and/or seeking an edge through speed and data crunching, rapidly identifying anomalies, and then trading at warp speed. Many hundreds of billions of dollars now take this route into the markets. And results have proven that this approach can work; some of these funds have done fabulously well.

 

So, stepping back, it becomes clear that the trillions of dollars invested through passive strategies and ETFs basically piggybacks on the decisions of active managers relying on traditional analysis of individual companies and sectors. Moreover, the hundreds of billions of dollars of money invested in quantitative, momentum, derivative, and volatility strategies, also piggybacks and even amplifies, the decisions made by traditional investors as those decisions become evident in price movements.

 

So the response to the pain inflicted by past booms and busts and insider trading scandals has created a situation today where the huge amounts of money moves in sync with an ever smaller base of active managers. Value investing based on analysis of individual companies has become an ever-smaller tail wagging an ever larger dog.

 

Perversely, this, in turn, has created a situation where in the next crash, Steve Cohen, the quant and momentum funds, and even the Warren Buffets will ultimately have no edge. All it will take to set the next crash in motion is for a fair number of investors to say, “gee I think I should shift more to cash.” Then the passive investment funds will be forced to sell, and they will sell regardless of the merits of any individual stock. This will cause volatility to rise and the billions of dollars of investments tied to volatility will also start selling, and as this is happening, the algorithmic traders, the momo guys and the others looking for direction to exploit will jump in juicing the sell off.  The trigger might be some external event, or something as banal as a simple change in mood, but no insider will have any better insight as to when this occurs than anyone with access to a newspaper.

 

As a coda, it’s worth noting that Steve Cohen has now been cleared to manage other people’s money. At the end of Black Edge the author quotes a savvy market player as saying that the day Cohen could do that, money would come pouring in. Well, according to the New York Times, that day is here and money is not pouring in. Maybe this is because his fees are too high, or because the insider trading scandal has made him tainted goods. Or maybe, it’s because investors doubt that he can achieve his former results without black edge.



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