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Today, the Lost Angeles TIMES published my oped as part of a a package on the first anniversary to Trump's election. Space was limited, so I tho...

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A REPUBLIC OF BIRDS: THOUGHTS FROM MIDWAY ATOLL


Thursday January 24, 2008

EUGENE LINDEN
Iíve been to a number of places where wild animals are trusting of humans, but perhaps none so unlikely as Midway Atoll, smack in the middle of the Pacific Ocean. After more than a century of abuse at the hands of man -- first being slaughtered for their feathers by hunters, then being paved over by Seabees, then shelled by the Japanese during World War II, and finally Osterized by the engines of the planes of the U.S. Strategic Air Command during the Cold War -- the albatross and other birds donít seem to bear a grudge. Maybe thatís because theyíve won. Albatross have succeeded where the Japanese military failed and have successfully taken over the island. And, they did it in a way that Mahatma Ghandi would applaud Ė through passive resistance. Itís only fair since theyíve have ancestral rights to Midway (or whatever itís called in Albatross-speak), but itís still both eerie and wonderful to see how the birds been able to enforce an avian eminent domain and build their nests on every available open space, including the middle of the islandís paths. Even more moving is the gracious way in which we humans have surrendered control and allowed the establishment of a republic of birds. For the most part itís a peaceable nation, and the citizens are irresistible, albeit short. Iíve discovered that itís impossible not to talk to them as I make my way around the island on foot or on bike. For their part, the albatross make we humans feel like superstars as we pick our way among them. The combined effect of tens of thousands of birds clacking in the background makes it seem as though our every move is accompanied by polite applause from a very large crowd. Their curiosity and clumsiness on land make them endearing. Every day, our group trades stories of heart-stopping take-offs as birds flap their wings and run wildly down impromptu runways that open in the middle of the nesting area. More often than not they inadvertently step on a nesting bird at some point during take off, eliciting an indignant squawk. The concept of zoning doesnít seem to have taken hold in bird land, although there are a couple of paths to the beaches that the albatross use for a more official runway, and the albatross using these runways even line up and (mostly) take turns. Landings are even more dramatic. If youíre an albatross, every landing seems to be an emergency landing. Unless thereís a stiff wind to land into, they have to put on the brakes immediately on touch-down, and quite often this ends up in a face plant, if not a collision with another hapless bird. In the air, though, they are magnificent, even heroic, and their life style would appeal to both feminists and the most fire-breathing moralists. Feminists would have a hard time finding fault with males who pitch in and take over care of the baby immediately after hatching while the mom gets a chance to rest up. Albatross may be one of the few species where spouses are actually an asset, rather than a clumsy menace, around newborns. On the other hand the ďvaluesĒ crowd might find inspiration in their commitment to monogamy since the birds mate for life. All in all Midway today is a happy place. The few humans working here or visiting here all care deeply about restoring the atoll as the haven for wildlife. God knows the albatross need it. Between the plastics that get into their digestive systems when they feed, to the impacts of global warming, the albatross run a gauntlet of threats during their life on the high seas. Once back on the atoll, however, at least for the moment, they find a haven where humans have turned the infrastructure of war and conflict towards their betterment. Theyíve managed to get a superpower as a protector and they donít control a drop of oil -- no mean trick for a birdbrain. Thatís an auspicious augury at the dawn of the 21st century.

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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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