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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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SANDY AND THE WINDS OF CHANGE: You don't need a climate scientist to see which way the wind blows


Friday November 30, 2012

 

by EUGENE LINDEN

 

Even as Sandy underwent its bizarre metamorphosis from hurricane to winter storm, the question arose in many inquiring minds (at least those not beholden to a solemn oath of climate-change denial): Was this historic storm a symptom of global warming? Climate science has two ready answers: Absolutely! And, of course not!

On the one hand, a warming globe makes megastorms more probable, while on the other, it is impossible to pin a global warming sticker on Sandy because the circumstances that turned it into a monster could have been mere coincidence.

There is, however, another way of looking at Sandy that might resolve this debate, and also help frame what we really should be worried about when it comes to global warming: An infrastructure created to defend against historical measures of worst-case natural threats was completely overpowered by this storm.

THEN AND NOW: Devastation from super storm Sandy

New York City's defenses were inadequate, and coastal defenses failed over a swath of hundreds of miles. Around the nation, such mismatches have been repeated ever more frequently in recent years.

This summer, barge owners discovered that dredging in the Mississippi River, predicated on the history of the river's ups and downs, left it too shallow for commercial traffic because of the intense Midwestern drought. And, famously, levees in New Orleans that were largely through the process of being improved even as Hurricane Katrina struck in 2005 were still breached in 50 places. Then, seven years to the day after Katrina struck, Plaquemines Parish was drowned by Hurricane Isaac in flooding residents described as worse than Katrina's.

It's true that factors other than megastorms — loss of flood plains, subsidence and neglect — can exacerbate a failure, but the number of failures of all types of defenses has been stunning.

Such failures are telling us that something new is afoot. Our levees, dredging protocols and, in New York City, subway tunnel designs and improvements incorporate society's best guess of what it takes to protect against the worst nature might throw at us. Such defenses are expensive, so a city or agency won't spend more than it deems necessary. But the consequences of underestimating are also so enormous — consider the billions that will be spent restoring Manhattan's infrastructure and ruined neighborhoods alone — that we routinely construct them to withstand 100- or even 500-year events, estimates based on probability calculations and history of rare, extreme disasters. Yet these days such events seem to occur annually.

This is borne out by statistics. Among the many records set by Sandy, one was for the highest wave ever recorded in New York Harbor: 32.5 feet. That eclipsed the previous record wave of 26 feet. When was the earlier record set? Just last year, courtesy of Hurricane Irene.

Another message from Sandy is the reminder that climate change is camouflaged. It arrives as familiar weather events and after slowly accumulating changes.

Sandy was unusual in many ways, but it is also easy to dismiss its significance because it started out as a hurricane and hurricanes have always marched up the Atlantic coast, even as late as November. As for the surge that inundated beach towns and city streets, it came on top of a sea level that has been rising slowly, on average less than one-tenth of an inch per year, though the pace has been accelerating in recent decades. The oceans are now roughly 9 inches higher than they were 140 years ago, and, for the most part, our sea defenses have not kept pace.

Perhaps the most important message from Sandy is that it underscores the enormous price of underestimating the threat of climate change. Damage increases exponentially even if preparations are only slightly wrong. In trying to protect Grand Forks, N.D., from a spring flood in 1997, the city used sandbags to defend against a high-water mark of 52 feet, comfortably above the 49-foot crest predicted by the National Weather Service but, unfortunately, below the 54-foot crest that occurred on April 21. It was only 10% higher than what was expected, but the damage was many hundred times greater than if the protections had not been breached; 50,000 homes suffered damage.

At some point the consensus among climate scientists might convince even those now in denial that they ignore the role of global warming in extreme weather events at the nation's peril. In the meantime, Sandy's trampling of the Northeast's defenses against the weather, as well as scores of other major infrastructure failures in the face of extreme floods, heat, drought and winds in the United States and around the world, tell us that climate change is already here.

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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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