Eugene Linden
home   |   contact info   |   biography   |   publications   |   radio/tv   |   musings   |   short takes   

Lastest Musing
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 ...

continue

Featured Book

The Ragged Edge of the World
Buy from Amazon

more info

Articles by Category
endangered animals
rapid climate change
global deforestation
fragging

Books

Winds of Change
Buy from Amazon

more info
Afterword to the softbound edition.


The Octopus and the Orangutan
more info


The Future In Plain Sight
more info


The Parrot's Lament
more info


Silent Partners
more info


Affluence and Discontent
more info


The Alms Race
more info


Apes, Men, & Language
more info

THE CRISES THAT DARE NOT SPEAK THEIR NAMES


Thursday May 15, 2014

[I'm going to continue to bang this drum until I get it right! This appeared in The Daily Beast]

In the first quarter of 2014, the economic impact of extreme weather related to climate change, combined with the inherent weakness of an economy suffering through a depression, produced a preliminary estimate of nearly no economic growth. This stark portrayal is a far cry from how the 0.1% GDP growth of the quarter has been presented. Rather, the narrative has gone something like this: Weather-related disruptions weighed upon business investment and consumer spending as the weak recovery continued.

Thus we continue to endure the two most consequential events of the recent decade without acknowledging either for what they are.

In the case of climate change, this timidity is understandable as change comes as weather and there will never be one clear event that signals indisputably that we’ve entered the climate rapids. Fifty years from now, however, odds are that historians will mark the first decade of this new millennium as the point at which global warming became undeniable, particularly in its economic impacts.

Similarly, future economic historians will likely mark the financial crash of 2008 as the beginning of a depression (it would be nice if they would come back in time and told us when it will end). Here too, it is understandable because there is such a high noise-to-signal ratio amid an incessant drumbeat of often conflicting economic data and so many false starts that it is extremely difficult to define a depression except in retrospect.

Part of the problem is that definitions of depression abound (the concept is so nebulous that the National Bureau of Economic Research, which officially calls recessions, demurs on the question of calling depressions). The description of depression that fits the present situation is a sustained period in which economic output falls substantially below an economy’s potential. Now five years into our “recovery” the Congressional Budget Office estimates that the economy this year will still fall short of its potential output by $723 billion (and this gap comes against figures for potential output that have been steadily marked down by the CBO since 2008, essentially lowering the bar).

Recognizing that things have truly changed has always been difficult for those living through inflection points in history. Those deepest inside the U.S. government and the intelligence community in the late 1980s were among the last to acknowledge that the Cold War was really over as the Soviet Union unraveled. “The Great Depression” as a proper noun only came into popular use in the 1950s, long after the event was over. As the economy bounced around in the mid-1930s, there were many premature calls that the crisis had ended, including one by President Roosevelt in 1936, after three years of impressive recovery, but just before a vicious new recession hit, and unemployment rose to new highs.

This blindness is deeply embedded in human nature. Such is our commitment to the world view we forge during our formative years that often we can’t see what is literally staring us in the face. Jerome Brumer, father of gestalt psychology, demonstrated this in a celebrated experiment in which he showed people a deck of cards salted with the wrong colors for different suits such as a red ace of spades. When the cards were turned over, most people saw them as normal. Only when they could linger for long periods would they see that something was amiss, but even then some people could not put their finger on what was wrong.

Does it matter whether and when we put a label on an era? Yes, greatly. Our reticence to state the obvious but unproven may be understandable, and even prudent, but it is not helpful. Recognizing that the changing climate carries with it harsh economic consequences might spur action to limit the harm. The Obama administration just did its part releasing a draft assessment of climate change asserting that it is already hurting Americans. Still, our current posture that global warming is a nebulous, far-off problem largely explains our complacency about a threat that has in the past been a civilization-killer.

Similarly, while economists will argue over whether the present period of near zero growth and stretched household finances is a depression long after the economy really does recover, acknowledging that for all but a tiny group of Americans the economy is in depression would do a world of good. For one thing, there might be less push for deficit reduction and more pressure for programs that might improve the incomes of ordinary Americans. One school of thought holds that FDR’s false belief in 1936 that the depression was over led his administration to tighten credit, pushing the fragile economy back into recession.

So, let’s acknowledge the obvious. The upside is that we might muster the political will to develop policies that match reality. Do we want those yet unborn historians (who are going to be royally annoyed about the world we bequeath them anyway) wondering how it was that we ignored what was staring us in the face?

contact Eugene Linden

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.



read more
  designed and maintained by g r a v i t y s w i t c h , i n c .
Eugene Linden. all rights reserved.