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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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THE OZONE CHRONICLES; HISTORY REPEATING AS TRAGEDY


Friday August 19, 2016

Joe Farnam, the dogged, data-driven discoverer of the ozone hole, died in 2013, three years before publication of findings showing that the ozone layer, which protects life on earth from UV radiation, has finally started to recover. This nascent recovery comes 42 years after atmospheric chemists first raised alarms about the threat chlorine compounds posed to this fragile shield, 34 years after Farman first saw an alarming drop in ozone in Antarctic, and 29 years after the world’s nations took action to phase out the chemicals, and it will still be decades before the ozone layer recovers completely. Were it not for Farman, the international community might not have taken action, and the world would be a far different place today, with unchecked UV radiation spreading cancer and havoc among humanity and devastating ecosystems and the food chain. It’s also worth revisiting this history because the struggle to identify and come to grips with this threat prefigured all the themes of the still-unresolved question of dealing with another man-made threat: climate change.
 
In 1982, when Farman’s monitoring equipment first showed a dip in ozone, he was tempted to dismiss the readings as instrument error. At that point, ozone levels had been stable for 25 years. A recheck validated the findings, however, and subsequent years showed an alarming acceleration in the deterioration of the ozone layer.
 
It was no mystery for scientists what was causing the decline. Eight years earlier, atmospheric scientists Sherwood Rowland, Mario Molina, and Paul Crutzen had published articles documenting that the release of certain chlorine compounds could start chemical reactions that destroyed atmospheric compounds. They won a Nobel Prize for their discovery. Later, prefiguring the playbook of climate denialists today, Congressman Tom Delay disparaged the award as the “Nobel Appeasement Prize.”
 
Even before Delay’s attempts to delay action on protecting the ozone in Congress, the industry, led by DuPont, which dominated the production of CFC’s (the chemicals deemed to destroy ozone), had organized a lobbying effort to discredit the science. They helped found The Alliance for Responsible CFC Policy in 1980, which challenged the scientists at every turn, spread alarm about the economic consequences of a CFC ban, and sowed disinformation in the media. They realized that given the inertia of American politics, they didn’t have to disprove the science. All they had to do was to argue that the science was inconclusive.
 
This was the exact same playbook used in the next decade by the Global Climate Coalition (also founded by Dupont), as well as numerous fossil fuel industry lobbying groups in so-far successful efforts to delay action on climate change. Indeed, a good number of the scientists who disparaged the threat of CFCs, including Fred Singer, Richard Lindzen, and Patrick Michaels, later turned up as leading climate change deniers.
 
In a typical example of industry casuistry, DuPont officials argued in the mid-1980s that no action was necessary because the market for CFCs was flat. What they well knew was that it only looked flat because a severe recession in 1982 distorted the figures, while, in fact, growth was accelerating as the economy recovered and emerging nations looked to increase refrigeration (CFCs were used as a refrigerant).
 
Once the evidence became incontrovertible, DuPont flipped and became an advocate for banning CFCs. While the action looked noble, DuPont had started developing alternatives to CFCs in the 1970s and had a huge lead on competitors. One wonders whether DuPont would have given its support for the 1987 Montreal Protocol if it were not to their economic advantage.
 
There are three lessons from the ozone chronicles, all of which have been ignored thus far in the struggle to deal with climate change:
 
1)   Industry requires regulation. In their no-holds barred attack on the scientists, duplicitous use of disinformation, and lobbying power, the chemical industry showed that all their executives cared about was profits, even if those profits came from chemicals that posed a threat to life on earth. Yet the mood in recent years has been decidedly anti-regulation.

2)   Politics matters. DuPont began to develop alternatives when Rowland and others showed the link between CFCs and the destruction of ozone. They tabled these efforts when Ronald Reagan was elected because they assumed no regulation was coming. In the U.K., the incoming Thatcher administration almost eliminated Farman’s ozone monitoring operation in a cost-cutting effort. How much more damage to the ozone layer might have occurred before some other agency discovered the problem? Today, Australia is considering the shut down of some of its ocean and atmospheric monitoring, vital to our understanding of climate change, in an effort to redirect science towards more commercial applications.

3)   Basic science matters. Were it not for the 25 years of data Farman had collected prior to 1982, he and his colleagues might not have noticed that something unprecedented was happening to the ozone layer. Before Rowland, Molina and Crutzen did their work, CFCs were regarded as entirely benign chemicals. It took basic science to make the leap connecting refrigerants in kitchens to the health of an atmospheric shield.  As we introduce more and more novel compounds into daily life, we need such imaginative scientists to determine whether they might also pose novel threats. Yet, both EPA and research budgets are continually under threat. The world remains one short-sighted budget cut away from blithely ignoring some new novel threat. Trouble is, we don’t know which cut it will be.

 
The world owes a huge debt to the diligence of Joe Farman who doggedly pursued what most would regard as mind-numbing data collection in the face of public indifference and political hostility. We need his successor now more than ever.
 
 

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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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