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Everyone Saw This Coming


Friday May 22, 2015

Twenty-seven years ago, when the world briefly awoke to the threats of global warming and tropical deforestation, scientists could only speculate on what changes might come in the future. Now, one need only look and observe.

Nineteen years ago, I went to Antarctica to report for Time magazine on the ways in which global warming was affecting the frozen continent. One concern was the stability of the West Antarctic Ice Sheet (or WAIS).

In 1996, scientists had detected an increase in the velocity of the so-called “ice streams,” which transport ice from the interior of the immense glacier to the shore. The fear was that as WAIS diminished, salt water might intrude under the ice and eventually cause it to float, raising sea level around the world, and inundating large swaths of Florida, not to mention Bangladesh, Indonesia and other low lying areas that are home to hundreds of millions of people.

This year, Eric Rignot, a scientist with NASA’s Jet Propulsion Laboratory, published a study confirming these fears with the stark conclusion that the ice sheet is in a state of “irreversible decline,” and in early May, Princeton University researchers released a new study confirming the accelerating melting.

The great ice sheet won’t collapse any time soon, but it’s a chilling thought in a warming world that an ice sheet that has been stable through the entire time modern humans have existed has now begun to come apart.

More than 20 years ago, INPE, Brazil’s Space Agency published studies arguing that continued cutting of the Amazon was diminishing the vast forest’s ability to recycle moisture. Water – it used to be seven trillion tons each year – evaporated from the Amazon forest rises above the forest, bounces south along the Andes, and then is carried by prevailing winds, first across the dryer areas of southern Brazil and then, after traversing the Atlantic, to South Africa, where it nourishes the corn crop. Since then, the forest has shrunk by an area equivalent to the size of Texas, and now residents of Sao Paulo, the hemisphere’s largest city, desperately scrabble for water after multiple years of drought have desiccated the reservoirs.

And of course, at the same time, California is trying to cope with the worst drought in its modern history. This drought was predicted 18 years ago by Richard Seager of Columbia University, who in 1998 published a paper in Science arguing that a warming world shifted the global precipitation patterns pole ward leaving California and other mid-latitude regions in a rain shadow. Exacerbating California’s problems has been a diminished snowpack – this year at 6 percent of normal. Ordinarily, the snowpack stores water and then melting acts as a meter, delivering water during the dry summer months. Tim Barnett of Scripps Oceanographic Institute first predicted 15 years ago that the combination of drought and warming would have this result.

Are you seeing the pattern here? Time and again, the world’s best scientists have done their job and made predictions based on the best available evidence, only to watch in dismay as their predictions come true because an oblivious world fails to act.

Many other predictions made about the likely consequences of global warming have come to pass: more extreme weather events (a drumbeat of such studies the mid-1990s, with the most recent published in Nature Climate Change on April 27); the disappearance of arctic sea; the collapse of fish populations in the Pacific; and even the series of frigid winters in the Northeast, fueled by a slowdown of the ocean circulation pattern that distributes heat from the tropics to the North Atlantic (predicted by Wallace Broecker of Lamont-Doherty Earth Observatory in an article in Science in 1997, and now back in the news).

Can it be said unequivocally that the drought in California is related to climate change, or that Sao Paulo’s water crisis is tied to cutting of the Amazon, or that there is, in fact undeniable evidence of an increase in extreme weather events? Nope, weather might be the most complicated phenomenon on the planet, influenced at any given time by myriad cycles as well as by such disparate factors as air pollution, land, even the expansion of cities, as well as the difficulty of obtaining consistent measurements on a global scale.

As new predictions of past decades come to pass, however, it makes it harder to explain these changes as coincidence. And there are quite unequivocal signals of a warming planet. Sea level rise, resulting from increased melting of ice and the thermal expansion of the oceans, offers a mute, global signal of a warming planet. Moreover, sea level is rising much faster than predicted, possibly because ice sheets in Greenland and Antarctica are melting more rapidly than predicted.

Could any of these unfortunate events have been prevented? Of course! Fifty years ago, Rachel Carson published Silent Spring, which warned that unchecked use of DDT would lead to the collapse of bird populations. The United States and other developed nations banned the pesticide, and bird populations have recovered to the point where bald eagles visit New York City (China ignored the warnings about DDT, and has suffered the silent spring that Carson predicted). Dealing with greenhouse gas emissions is vastly more complicated, but it is highly likely that the world would be in a better position to fight the threat now had it begun to take action in 1988.

Now we’ve gone backwards. Thanks to a campaign to discredit the threat of climate change financed by the fossil fuel industry and vigorously promoted by Fox News and other right-leaning media, fewer Americans think global warming is human caused than they did eight years ago, according to a recent study conducted by Anthony Leiserowitz* of Yale University.

Think about that: even as predictions of past decades have become reality, the American attitude about global warming has shifted towards “prove it.” One thing is certain: we’ve forfeited the right to say, “Nobody saw this coming.”

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.



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