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IS OUR BRAND OF CAPITALISM MAKING US STUPID


Tuesday August 30, 2011

 

Eugene Linden


           How can a society that contains so much individual brilliance act so collectively dumb? Does it matter that we know that there is a cliff ahead if we still go racing off the edge?  The Wikileaks publication of State Department emails demonstrated that there is tremendous expertise at the ground level in foreign policy.  That didn’t stop us from charging into what has been called the “most feckless” war in American history. The key to our success as a species has been the development of communication and cognitive skills that enable us to leverage our collective intelligence so that a group is vastly smarter than an individual.  In recent years, that seems to have gone into reverse. While individual brilliance abounds, collective stupidity prevails.

Consider a few recent examples:

The Ongoing Financial Crisis:

            The most devastating financial crisis since the Great Depression followed the dismantling of reforms put in place during and after the 1930s to prevent institutions from bringing about the very financial collapse we just experienced. While there were many tributaries to the meltdown, a common element was a system of incentives that was optimized to reward those who made the biggest bets. Penalties for failure were gradually stripped away, and the costs dumped on taxpayers. Does anyone think that the Dodd-Frank package of financial regulation package signed into law by President Obama has eliminated these incentives, or that if it turns out that new regulations actually impede financial institution profits that they will stay in place?

Given that the crisis wiped out $13 trillion in national wealth and has brought much of the middle class to the brink of insolvency, one would think that voters, who vastly outnumber the rich, would insist on enacting a robust regulatory framework. One would be wrong.
     
And now, carrying forward its proud tradition of doing the wrong thing at precisely the wrong time, Congress just forced through, and the President signed into law, a series of spending cuts in return for allowing the US government to pay bills it had already incurred. This will shrink government spending even as the economy slows, removing any doubt that we will slip back into recession and unemployment will worsen. Congress and the president have thus exactly repeated the mistake of FDR, who agreed to cuts in 1937 that plunged the US back into the Great Depression.


The Deepwater Horizon oil spill:

            The Gulf of Mexico oil spill of 2010, the most catastrophic environmental event in American history, directly followed from the neutering of regulations, safety mechanisms, and procedures put in place after earlier spills such as the Ixtoc Spill of 1979, and the Exxon Valdez spill in Alaska in 1989.  Does anyone seriously believe that new regulations that arise from this disaster won’t also be neutered?  We need oil, and the easy-to-find oil is gone so we need to drill in the most inaccessible, politically hostile, and/or environmentally vulnerable places on the planet.

Climate Change:

            Now here’s a problem perfectly designed for a species with an abilitiy to anticipate and avoid disaster! The science of the greenhouse effect that underlies concerns that emissions of C02 are changing climate is uncontroversial. There is overwhelming agreement among climate scientists that human-sourced emissions, largely traced to the use of fossil fuels, are already warming the planet; climate historians have vividly documented how civilizations are vulnerable to climate change, and since the 1980s, policy-makers have been discussing ways to reduce emissions.
        
So what has the U.S. done to avert the threat? Nothing! Despite 30 years of verbiage and negotiations, the recession has done more to limit U.S. emissions than anything we have done legislatively. The pattern for species ranging from fruit flies to elephants, and, yes, humans, has been for numbers to explode when the climate is favorable and plummet when it turns hostile. Our numbers have exploded in the climatically benign years since the end of the last Ice Age. Will it be different this time if climate turns hostile?

A Global Pandemic of Willful Blindness

            America has no monopoly on collective dumbness – after all Japan, perhaps the most rational nation on the planet, saw fit to site nuclear power plants in areas vulnerable to both earthquakes and tsunamis, and Europe continues to pile blunder upon blunder as it tries and fails to contain its own financial crisis. Time and again the best and brightest have alerted society to looming problems, but a persistent pattern has been to ignore the warnings, ridicule the experts, and suffer the consequences.

The pathetic refrain of recent years  -- “nobody saw this coming” –is always a self-serving lie.  Something is making us stupid.  My candidate is the way we practice capitalism, specifically the skewed incentives that promote hyper-focus on short-term gains, while leaving us effectively blind to long-term threats.
      
In each case cited above, actions to head off a threat were perceived to impinge on present profits, and, in modern market economies, we consistently make the decision that we’d rather head off a cliff in the future than limit the gains of those with access to the levers of power. In all these cases, economic interests ultimately control the lawmakers.  We’ve created a system that leaves us constantly surprised by the obvious.
          
I’m certainly not arguing for central planning – the failed communist states constitute a monument to collective stupidity. But there is a middle ground. Consider Canada, the friendly giant to the north, which seems to be able to regulate without suffocating innovation. Can this be fixed in the U.S.? Sure! Will it be fixed? Probably not, at least, not without shock therapy far worse than what we have recently endured, and that’s exactly what we are rocketing towards right now.

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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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