Eugene Linden
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OUR CONFEDERACY OF DUNCES

            The Darwin Award confers mock recognition on individuals killed by their own stupidity, thereby improving the gene pool by removing themselves from it. If there existed such an award at the national level, the U.S. of today would be ...

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Afterword to the softbound edition.


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Silent Partners
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HE WAS LOST AND NOW HE IS FOUND.


Friday September 15, 2006

HE WAS LOST AND NOW HE IS FOUND. On Saturday, August 12, we were having a family barbecue in Pelham New York, having just moved up from Washington, DC a week earlier. It was just my wife and our two kids and her brother, his wife and their twins. The evening was thoroughly pleasant. We'd let Murghatroyd, our 11 year-old Bengal, out of the house for the first time that day, and he was overjoyed. Murghy was an outdoor cat in the extreme, and he'd made our life a living hell while he was cooped up during the week as we tried to habituate him to the new surroundings. Now outside, he rolled luxuriantly in the grass and repeatedly showed up during dinner to hop on the lap of various guests, and play the role of host. Midway through the evening we heard a scuffle off in the bushes, and then the smell of skunk spray wafted our way. Murghy didn't return to the party, but we didn't think much of it. He was our smartest cat by far, and we trusted him (Lucy, another Bengal was definitely more suburban in her inclinations, and, after a Oliver Twist kittenhood, our two other adopted strays were never going to venture far from the food bowl). But then Murghy didn't show up the next day, the next, nor the next, and with each passing day, a pall deepened over the remainder of the summer and an ache took hold somewhere deep. I've always considered myself level headed about animals. Nothing is more elegant and interesting than the genius of evolution, and I have spent many years investigating evidence that the evolutionary forces that produced consciousness and other higher mental abilities in humans also produced those abilities in other species. But, I've always shied from some of the more radical ideas about alternative intelligences in other animals, e.g. the notion that cats communicate with us by planting images directly in our subconscious - “mind bombs” as one woman wrote when explaining how her cat had alerted her that the house was on fire. That is, I tended to discount these ideas until my wife and I began receiving missives very much like what the woman had described. While I've been accused of being apocalyptic in some of my writing, on a daily basis I tend to be optimistic. Mary, by contrast, likes to prepare herself for bad news. Our rented house in Pelham was not far off a golf course. I tried to take comfort when one of my neighbors described the course as “cat heaven,” with vast troves of small animals for a cat to feast on. I envisioned Murghy's walkabout as something like a Tahitian vacation. Besides, Murghy had a collar with our phone number on it. There was always a chance that a Good Samaritan would give us a call. Mary spoke to another neighbor, however, who told of a surge of pet disappearances in the neighborhood, and mentioned rumors of a pet-killing coyote in the vicinity. We got a call about the body of a cat that someone had found near the golf course, and Mary reported that the much worked-over corpse bore some resemblance to Murghy. There was a resemblance, but I convinced myself that the color was a bit too light. We put up posters and followed up leads when people called in. Every time our hopes were dashed. In some ways news was worse than no news. One ostensibly sighting placed him near the deadly confluence of two parkways. Reconnoitering following one phone call revealed that a very cute kitten was making a go of it as a stray (her welfare was being monitored by solicitous neighbors), and we were never able to run down the sightings of a larger cat that fit Murghy's description. After about ten days, the dreams began. I had them, Mary had them, even the kids had them. They were intense and good dreams: Murghy coming home, Murghy curled up in my lap. Ever the optimist, I thought of them as postcards - Murghy was telling us that he was alright; the Tahitian vacation was going well. I tried to send return messages as well, helpfully beaming out an image the landmarks in our neighborhood. Overcoming her instinct to protect herself against bad news, Mary put a positive spin on the dreams as well: Murghy was telling us that he was alive. Still, at eleven Murghy was no spring chicken, and beyond the golf course lay a rough world if you were a lost cat. Moreover, there was always the chance he'd set off with some hare-brained plan to get back to DC. I was outwardly optimistic, but deep down I started preparing myself for life without Murghy. August turned into September, and although there were pleasant moments, at some level I was holding my breath as my subconscious tried to figure out how to resolve my feelings about Murghy, who played a far larger role in my thoughts than you might expect of an animal that weighed 10 pounds and slept most of the day. Mary and I replayed every heartbreaking missed opportunity. None was more anguished than the discovery on Sept. 10 of a message from just the Good Samaritan we had been hoping for. The woman caller said that she had encountered a very friendly cat on the grounds of a hospital and that he let her see his collar and read the phone number. The problem was that the message was ten days old. We'd set up voice mail on our new phone, but, unbeknownst to us, some of our missed calls were recorded by the phone itself rather than voice mail. Mary discovered the message at one in the morning. I was long asleep since I had to get up at 6:45 in the morning. She woke me up however, and I felt a surge of hope and adrenaline, which, unfortunately, kept me up most of the short remainder of the night. Murghy was alive, but the idea that we might have missed our opportunity to find him was too painful to contemplate. The sighting placed Murghy about 15 miles north of Pelham. I was there by 7:30 on Sept 11, the next morning, calling for Murghy, handing out posters, and badgering everyone I could. Settling down I decided to think like a cat, and that led me to the back of the sprawling main building where the garbage was stored. I did a walk through and it looked promising, but I had handed out all my posters by this point, and I was also very late for work. Dejectedly, I left to get my car. On the floor of the car, I saw one last poster and so I drove back to the garbage area to leave it with one of the workers. I found someone who looked like he worked there and showed him the poster. He glanced at it, and then did a double-take. He said that a cat that looked like this had been hanging around for a week. He'd seen it as recently as the previous Friday. Other workmen came by and confirmed the sighting, pointing to a fenced-off area where the cat had been seen. Before leaving, I decided to walk over to the spot and try calling one more time. I saw movement on the other side of the fence. Then I saw a tail, and then I saw Murghy's beautiful face. I said, “Murghy,” and he, being a cat, said, “meow.” Then he said, “meow' about 25 times. There ensued a farcical series of maneuvers as I got inside the fence even as Murghy got out, but only a minute later we were re-united. He was skin and bone (putting paid to my reassuring delusion that he was off on a cat's version of a Tahitian vacation), but still very much Murghy. As I drove home, I called Mary and said, “somebody wants to talk to you.” In the days since we've tried to figure out how he got there. I know he's tried to tell me, but despite years of effort I still don't understand cat beyond a few rudimentary phrases. My best guess is that he somehow got to the Hutchison River Parkway and wandered north in the sward of wood and grass that borders the road. As for those messages, who knows? It would have been helpful had they have conveyed more information, but the sender was a cat (if in fact they were sent), and not Jack Bauer, and he was lost to boot. The key thing though is that they convinced us to retain hope, and perhaps our messages kept Murghy's hopes up as well. What matters most is that against all odds he's back, and our world was set right on again on, of all days, Sept. 11.

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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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