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In Memorium: Koko the Gorilla

Koko the gorilla died on June 19. She and a female chimpanzee named Washoe (who died in 2007) played an outsized role in changing how we view animal intelligence. Their accomplishments inaugurated deep soul-searching among us humans about the moral basis of our relationship with nature. Koko and Was...

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BUSINESS DISCOVERS THE COSTS OF EXTREME WEATHER -- THAT'S GOOD NEWS!


Saturday February 15, 2014

        The weather has become the go-to excuse for economists and businessmen who want to explain poor performance. “Unusually, disruptive weather across large stretches of the country kept people indoors,” explained Lawrence Yun, the chief economist of the National Association of Realtors, in accounting for a slowdown in home sales in Dec. Speaking on CNBC, Diane Swonk, the chief economist of Mesirow Financial, used the January chill that gripped much of the nation to explain disappointing numbers on U.S. auto sales. “It literally freezes the economic activity,” she noted. Similar explanations were offered for the very weak ISM manufacturing numbers released in early February. Economists blamed the huge miss on Non-Farm Payroll numbers in Dec.  – 74,000 instead of the consensus expectation of 197,000 – on bad weather. The same excuse was trotted out when the January ADP number came in weak. The Bureau of Labor Statistics did not blame the weak NFP number of 113,000 on the weather, but pundits were quick to point out that the January employment survey was taken during the one mild week during the month. To top it off the weather has been trotted out as an excuse for a possibly weak GDP number for the first quarter of 2014 – which really jumps the gun because the quarter is not yet half over.  As many financial bloggers have noted, the weather excuse has become the economic equivalent of “the dog ate my homework.”
       

          Change the word “weather” to the phrase “climate change,” however, and be prepared for howls of protest. Though this is another dismaying example of the how toxic the phrase has become, the universal acceptance that extreme weather has economic consequences points to a path towards awakening the public to the risks we all face. This is simply because we will experience climate change as weather, and the more businesses and municipalities find themselves suffering economically because of extreme weather events, the more they will realize that even more frequent extreme storms, temperatures, floods, and droughts are a risk factor (to use the language of corporate reports) going forward.

           No one would claim that all extreme weather events are the result of global warming, but one of the most widely agreed-upon consequences of warming is an increase in extreme weather events. Climate is what you expect, and weather is what you get. If the weather we experience ever more frequently diverges from expectations, then it is natural to wonder whether climate is changing.

          One of the biggest impediments to any public awakening is that the phrase “global warming” implies that the extremes will only be in the form of heat and everywhere at once. Hence the blizzard of smugness – “where’s your warming?” – that was an insufferable fellow-traveler with the arrival of the Polar Vortex in January (an easy answer, by the way, is “Alaska” where unseasonable warmth led to a massive avalanche that isolated the town of Valdez for two weeks).  When climate changes, however, the scientific consensus is that the transition is not smooth. The term favored by climate scientists is “flicker” where climate jumps back and forth between hot and cold and wet and dry until it finally settles in a new state.  In this context, rather than putting aside concerns about global warming when the temperature plunges, we might well wonder whether or not the extreme is yet another data point in an accelerating pattern of extreme events.
           

        There have been numerous studies of the potential economic impact of climate change (I helped edit one published by the UNDP and World Bank in 2005), the most recent being “The Weather Business” published by the German financial colossus Allianz. Many of the earlier studies speculated about future events, while now, a businessman, economist, a mayor, governor, or President doesn’t need a study to envision the costs of weather catastrophes. All they have to do is look at their corporate results, or busted budgets. The increasing pace of extreme weather events is telling us that climate is changing and it is costing us money now (the Allianz report estimated the cost of worldwide weather disasters in 2012 to be $170 billion).
           

         Which brings us back to the question of the difference between thinking about the costs of extreme events as “weather” related losses or as costs related to “climate change.” Attributing poor performance to the weather contains an implicit assumption that this was a one-time event, not likely to be repeated as things revert to normal. Recognizing that an event might – might – be related to changing climate means that a CEO or political leader recognizes that he or she should be prepared for things not returning to normal. Which corporate leader or politician would you prefer to have making decisions about budgets and strategy?
          

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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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