Eugene Linden
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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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PlayingwithFire

Destruction of the Amazon is "one of the great tragedies of history"
BY EUGENE LINDEN


Monday, Sep. 18, 1989
The skies over western Brazil will soon be dark both day and night. Dark from - the smoke of thousands of fires, as farmers and cattle ranchers engage in their annual rite of destruction: clearing land for crops and livestock by burning the rain forests of the Amazon. Unusually heavy rains have slowed down the burning this year, but the dry season could come at any time, and then the fires will reach a peak. Last year the smoke grew so thick that Porto Velho, the capital of the state of Rondonia, was forced to close its airport for days at a time. An estimated 12,350 sq. mi. of Brazilian rain forest -- an area larger than Belgium -- was reduced to ashes. Anticipating another conflagration this year, scientists, environmentalists and TV crews have journeyed to Porto Velho to marvel and despair at the immolation of these ancient forests.

After years of inattention, the whole world has awakened at last to how much is at stake in the Amazon. It has become the front line in the battle to rescue earth's endangered environment from humanity's destructive ways. "Save the rain forest," long a rallying cry for conservationists, is now being heard from politicians, pundits and rock stars. The movement has sparked a confrontation between rich industrial nations, which are fresh converts to the environmental cause, and the poorer nations of the Third World, which view outside interference as an assault on their sovereignty.

Some of the harshest criticism is aimed at Brazil. The largest South American country embraces about half the Amazon basin and, in the eyes of critics, has shown a reckless penchant for squandering resources that matter to all mankind. Government leaders around the world are calling on Brazil to stop the burning. Two delegations from the U.S. Congress, which included Senators Al Gore of Tennessee and John Chafee of Rhode Island, traveled to the Amazon earlier this year to see the plight of the rain forest firsthand. Says Gore: "The devastation is just unbelievable. It's one of the great tragedies of all history."

The vast region of unbroken green that surrounds the Amazon River and its tributaries has been under assault by settlers and developers for 400 years. Time and again, the forest has defied predictions that it was doomed. But now the danger is more real and imminent than ever before as loggers level trees, dams flood vast tracts of land and gold miners poison rivers with mercury. In Peru the forests are being cleared to grow coca for cocaine production. "It's dangerous to say the forest will disappear by a particular year," says Philip Fearnside of Brazil's National Institute for Research in the Amazon, "but unless things change, the forest will disappear."

That would be more than a South American disaster. It would be an incalculable catastrophe for the entire planet. Moist tropical forests are distinguished by their canopies of interlocking leaves and branches that shelter creatures below from sun and wind, and by their incredible variety of animal and plant life. If the forests vanish, so will more than 1 million species -- a significant part of earth's biological diversity and genetic heritage. Moreover, the burning of the Amazon could have dramatic effects on global weather patterns -- for example, heightening the warming trend that may result from the greenhouse effect. "The Amazon is a library for life sciences, the world's greatest pharmaceutical laboratory and a flywheel of climate," says Thomas Lovejoy of the Smithsonian Institution. "It's a matter of global destiny."

To Brazilians, such pressure amounts to unjustified foreign meddling and a blatant effort by the industrial nations to preserve their economic supremacy at the expense of the developing world. Brazilian President Jose Sarney has denounced the criticism of his country as "unjust, defamatory, cruel and indecent." How can Brazil be expected to control its economic development, he asks, when it is staggering under a $111 billion foreign-debt load? By what right does the U.S., which spews out more pollutants than any other nation, lecture poor countries like Brazil on their responsibilities to mankind?

Yet Sarney is caught between conflicting, and sometimes violent, forces within his nation. On one side are the settlers and developers, often backed by corrupt politicians, who are razing the forests to lay claim to the land. On the other are hundreds of fledgling conservation groups, along with the Indian tribes and rubber tappers whose way of life will be destroyed if the forests disappear. The clash has already produced the world's most celebrated environmental martyr, Chico Mendes, a leader of the rubber tappers who was murdered for trying to stand in the way of ranchers.

The passions behind the fight are easy to understand for anyone who has seen the almost unimaginable sweep of the Amazon basin. The river and forest system covers 2.7 million sq. mi. (almost 90% of the area of the contiguous U.S.) and stretches into eight countries besides Brazil, including Venezuela to the north, Peru to the west and Bolivia to the south. An adventurous monkey could climb into the jungle canopy in the foothills of the Andes and swing through 2,000 miles of continuous 200-ft.-high forest before reaching the Atlantic coast. The river itself, fed by more than 1,000 tributaries, meanders for 4,000 miles, a length second only to the Nile's 4,100 miles. No other river compares in volume: every hour the Amazon delivers an average of 170 billion gal. of water to the Atlantic -- 60 times the flow of the Nile. Even 1,000 miles upriver, it is often impossible to see from one side of the Amazon to the other.

The jungle is so dense and teeming that all the biologists on earth could not fully describe its life forms. A 1982 U.S. National Academy of Sciences report estimated that a typical 4-sq.-mi. patch of rain forest may contain 750 species of trees, 125 kinds of mammals, 400 types of birds, 100 of reptiles and 60 of amphibians. Each type of tree may support more than 400 insect species. In many cases the plants and animals assume Amazonian proportions: lily pads that are 3 ft. or more across, butterflies with 8-in. wingspans and a fish called the pirarucu, which can grow to more than 7 ft. long. Amid the vast assortment of jungle life, creatures command every trick in nature's book to fool or repel predators, attract mates and grab food. Caterpillars masquerade as snakes, plants exude the smell of rotting meat to attract flies as pollinators, and trees rely on fish to distribute their seeds when the rivers flood.

But the diversity of the Amazon is more than just good material for TV specials. The rain forest is a virtually untapped storehouse of evolutionary achievement that will prove increasingly valuable to mankind as it yields its secrets. Agronomists see the forest as a cornucopia of undiscovered food sources, and chemists scour the flora and fauna for compounds with seemingly magical properties. For instance, the piquia tree produces a compound that appears to be toxic to leaf-cutter ants, which cause millions of dollars of damage each year to South American agriculture. Such chemicals promise attractive alternatives to dangerous synthetic pesticides. Other jungle chemicals have already led to new treatments for hypertension and some forms of cancer. The lessons encoded in the genes of the Amazon's plants and animals may ultimately hold the key to solving a wide range of human problems.

Scientists are concerned that the destruction of the Amazon could lead to climatic chaos. Because of the huge volume of clouds it generates, the Amazon system plays a major role in the way the sun's heat is distributed around the globe. Any disturbance of this process could produce far-reaching, unpredictable effects. Moreover, the Amazon region stores at least 75 billion tons of carbon in its trees, which when burned spew carbon dioxide into the atmosphere. Since the air is already dangerously overburdened by carbon dioxide from the cars and factories of industrial nations, the torching of the Amazon could magnify the greenhouse effect -- the trapping of heat by atmospheric CO2. No one knows just what impact the buildup of CO2 will have, but some scientists fear that the globe will begin to warm up, bringing on wrenching climatic changes.

As the potential consequences of rain-forest destruction became more widely known, saving the Amazon became the cause of 1989. In New York City, Madonna helped organize a benefit concert called "Don't Bungle the Jungle," which also featured the B-52s and the Grateful Dead's Bob Weir. Xapuri, the remote town where Mendes lived and died, has been besieged by journalists, agents and pilgrims. Robert Redford, David Puttnam and other prominent moviemakers have sought the rights to film the Mendes story.

In the face of pressure from abroad and complaints from environmentalists at home, Brazil has grudgingly begun to respond. In April, only a few months after denouncing the environmental movement as a foreign plot to seize the forests, the Sarney administration announced a hastily patched-together conservation package dubbed Our Nature. Much of the language was ambiguous, but the program contained promising provisions, such as the temporary suspension of tax incentives that spur the most wasteful forest exploitation. Says Celio Valle, director of ecosystems at the government's newly created environmental agency: "Before, we used to consider Brazilian environmental groups as the enemy, but now we consider them allies." Amazonian development may become a significant issue in this fall's presidential campaign. Fernando Collor de Mello, a member of the conservative National Reconstruction Party and a leading candidate to succeed Sarney, has said he believes in preserving the forests, though critics doubt his sincerity.

Many Brazilians still believe the Amazon is indestructible -- a green monster so huge and vital that it could not possibly disappear. Asked about a controversial hydroelectric project that might flood an area as large as Britain, a Brazilian engineering consultant said, "Yes, that's a big area, but in terms of the Amazon it's small." Maintained Sarney recently: "It's not easy to destroy a rain forest. There are recuperative powers at work."

Yet the rain forest is deceptively fragile. Left to itself, it is an almost self-sustaining ecosystem that thrives indefinitely. But it does not adapt well to human invasions and resists being turned into farm- or ranchland. Most settlers find that the lush promise of the Amazon is an illusion that vanishes when grasped.

The forest functions like a delicately balanced organism that recycles most of its nutrients and much of its moisture. Wisps of steam float from the top of the endless palette of green as water evaporates off the upper leaves, cooling the trees as they collect the intense sunlight. Air currents over the forest gather this evaporation into clouds, which return the moisture to the system in torrential rains. Dead animals and vegetation decompose quickly, and the resulting nutrients move rapidly from the soil back to growing plants. The forest is such an efficient recycler that virtually no decaying matter seeps into the region's rivers.

But when stripped of its trees, the land becomes inhospitable. Most of the Amazon's soil is nutrient poor and ill suited to agriculture. The rain forest has an uncanny capacity to flourish in soils that elsewhere would not even support weeds.

Throughout history, would-be pioneers and developers have discovered just how unreceptive the Amazon can be. Henry Ford tried twice to carve rubber empires out of the rain forest in the 1920s and '30s. But when the protective canopy was cut down, the rubber trees withered under the assault of sun, rain and pests. In 1967 Daniel Ludwig, an American billionaire, launched a rashly ambitious project to clear 2.5 million acres of forest and plant Gmelina trees for their timber. He figured that the imported species would not be susceptible to Brazil's pests. Ludwig was wrong, and as his trees died off, he bailed out of the project in 1982.

The Brazilian government, meanwhile, came up with development schemes of its own. In the early 1970s the country built the Trans-Amazon Highway, a system of roads that run west from the coastal city of Recife toward the Peruvian border. The idea was to prompt a land rush similar to the pioneering of the American West. To encourage settlers to brave the jungle, the government offered transportation and other incentives, allowing them to claim land that they had "improved" by cutting down the trees.

But for most of the roughly 8,000 families that heeded the government's call between 1970 and 1974, the dream turned into a bitter disappointment. The soil, unlike the rich sod in the Western U.S., was so poor that crop yields began to deteriorate badly after three or four years. Most settlers eventually gave up and left.

Yet the failed dreams of yesterday have not discouraged Brazil from conjuring up more grand visions for today. The country has continued to build roads, dams and settlements, often with funding and technical advice from the World Bank, the European Community and Japan. Two of the largest -- and, to the rain forest, most threatening -- projects are Grande Carajas, a giant development program that includes a major mining complex, and Polonoroeste, a highway-and-settlement scheme.

The $3.5 billion, 324,000-sq.-mi. Grande Carajas Program, located in the eastern Amazon, seeks to exploit Brazil's mineral deposits, perhaps the world's largest, which include iron ore, manganese, bauxite, copper and nickel. The principal iron-ore mine began production in 1985, and its operation has little impact on the forest. The problem, however, is the smelters that convert the ore into pig iron. They are powered by charcoal, and the cheapest way to obtain it is by chopping down the surrounding forests and burning the trees. Environmentalists fear that Grande Carajas will repeat the dismal experience of the state of Minas Gerais in southeastern Brazil, where pig-iron production consumed nearly two-thirds of the state's forests.

In the other huge project, Polonoroeste, the government is trying to develop the sprawling western state of Rondonia. The program, backed by subsidies and built around a highway through the state called BR-364, was designed to relieve population pressures in southern Brazil. But Polonoroeste has made Rondonia the area where rain-forest destruction is most rapid, and the focal point of the fight to save the Amazon.

The results of the development have been chaotic and in some cases tragic. Machadinho, for instance, was supposed to be a model settlement village with gravel roads, schools and health clinics. But when a surge of migrants traveled down BR-364 to Machadinho in 1985, orderly development became a pell- mell land grab. Settlers encountered the familiar scourges of the rain forest: poor soil and inescapable mosquito-borne disease. Decio Fujizaki, a settler who came west four years ago, has just contracted malaria for the umpteenth time. Says he: "I always wanted my own plot of land. If only it wasn't for this wretched disease."

Instead of model settlements, the Polonoroeste project has produced impoverished itinerants. Settlers grow rice, corn, coffee and manioc for a few years until the meager soil is exhausted, then move deeper into the forest to clear new land. The farming and burning thus become a perpetual cycle of depredation. Thousands of pioneers give up on farming altogether and migrate to the Amazon's new cities to find work. For many the net effect of the attempt to colonize Rondonia has been a shift from urban slums to Amazonian slums. Says Donald Sawyer, a demographer from the University of Minas Gerais: "The word is out that living on a 125-acre plot in the jungle is not that good."

The abandoned fields wind up in the hands of ranchers and speculators who have access to capital. Thanks to tax breaks and subsidies, these groups can often profit from the land even when their operations lose money. According to Roberto Alusio Paranhos do Rio Branco, president of the Business Association of the Amazon, nobody would farm Rondonia without government incentives and price supports for cocoa and other crops.

Rondonia's native Indians have fared worse than the settlers. Swept over by the land rush, one tribe, the Nambiquara, lost half its population to violent clashes with the immigrants and newly introduced diseases like measles. Jason Clay, director of research for Cultural Survival, an advocacy organization for the Indians, says that when the Nambiquara were relocated as part of Polonoroeste, the move severed an intimate connection, forged over generations, to the foods and medicines of their traditional lands. That deprived them of their livelihood and posterity of a wealth of information about the riches of the forest. Says Clay: "Move a hunter-gatherer tribe 50 miles, and they'll starve to death."

Amid the suffering of natives and settlers, the one constant is that deforestation continues. Since 1980 the percentage of Rondonia covered by virgin forest has dropped from 97% to 80%. Says Jim LaFleur, an agricultural consultant with 13 years' experience working on colonization projects in Rondonia: "When I fly over the state, it's shocking. It's like watching a sheet of paper burn from the inside out."

A similar debacle could occur in the western state of Acre. It is still virtually pristine, having lost only 4% of its forests, but the rate of deforestation is increasing sharply as cattle ranchers expand their domain. Development in Acre has sparked a series of bloody confrontations between ranchers and rubber tappers, who want to preserve the forests so they can save their traditional livelihood of harvesting latex and Brazil nuts. It was this conflict that killed Mendes.

This courageous leader did not set out to save the Amazon but to improve the lot of rubber tappers, or seringueiros. He and his men would try to dissuade peasants from clearing land. The ranchers were eager to get rid of him, but he survived one assassination attempt after another. The conflict finally came to a head last year, when Mendes confronted a rancher named Darli Alves da Silva, who wanted to cross land claimed by rubber tappers to cut an adjacent 300-acre plot. After Mendes and a group of 200 seringueiros peacefully turned back the rancher and 40 peons, death threats against him grew more frequent. In December he was killed with a shotgun as he stepped out of his doorway. Alves and two of his sons were convicted of the murder but have appealed the verdict.

Mendes became a hero to environmentalists not only because he fought and died to stop deforestation but also because of the way of life he was defending. The rubber tappers are living proof that poor Brazilians can profit from the forest without destroying it. According to Stephan Schwartzman of the Environmental Defense Fund, seringueiros achieve a higher standard of living by harvesting the forest's bounty than do farmers who cut the forest and plant crops.

One of Mendes' most important achievements was to help convince the Inter- American Development Bank to suspend funding temporarily for further paving of BR-364 between Rondonia and Acre. But the Brazilian government is again seeking the $350 million needed to complete the road all the way to Peru, a prospect that alarms environmentalists. "One lesson we have learned in the Amazon is that when you improve a road, you unleash uncontrolled development on the rain forest," says John Browder, a specialist on Rondonia's deforestation from Virginia Polytechnic Institute.

Among other things, environmentalists fear that completion of the road will provide entree for Japanese trading companies that covet the Amazon's vast timber resources. Acre's governor, however, argues that the road is needed to end the state's isolation and claims that the state will not repeat the mistakes of Rondonia.

The debate over the Acre road places environmentalists in an uncomfortable position, essentially telling Brazilians that they cannot be trusted with their own development. Raimundo Marques da Silva, a retired public servant who helped build Acre's original dirt highway, asks, "How would Americans feel if years ago we had told them they could not build a road from New York to California because it would destroy their forests?"

Still, some Brazilians do accept that the outside world has a legitimate interest in the Amazon. Jose Lutzenberger, an outspoken environmentalist, notes that the Brazilians trying to develop the rain forest are themselves outsiders to the area. "This talk of 'We can do with our land what we want' is not true," he says. "If you set your house on fire it will threaten the homes of your neighbors."

If the rain forest disappears, the process will begin at its edges, in places such as Acre and Rondonia. While the Amazon forest as a whole generates roughly half of its own moisture, the percentage is much higher in these western states, far from the Atlantic. This means that deforestation is likely to have a more dramatic impact on the climate in the west than it would in the east. "Imagine the effects of a dry season extended by two months," says Fearnside. The process of deforestation could become self-perpetuating as heat, drying and wind cause the trees to die on their own.

This does not have to happen. A dramatic drop in Brazil's birth rate promises to reduce future pressures to cut the forests, and experts believe the country could halt much of the deforestation with a few actions. By removing the remaining subsidies and incentives for clearing land, Brazil could both save money and slow the speculation that destroys the forests. Many environmentalists prefer this approach to the enactment of new laws. Brazilians have developed a genius, which they call jeito, for getting around laws, and many sound environmental statutes on the books are ignored.

The government could also stop some of the more wasteful projects it is currently planning. Part of the problem in the Amazon has been ill-conceived plans for development that destroy forests and drive the country deeper into debt. Most hydroelectric dams, for example, have proved unsuitable in the region. The Balbina Dam, which was completed in 1987 and began operating early this year, flooded a huge area at great cost to produce relatively little power. It killed trees, poisoned fish and provided breeding grounds for billions of malarial mosquitoes. Despite this experience, the government plans to build scores of additional dams.

Fabio Feldmann, the leading environmentalist in the Brazilian congress, alleges that much of the momentum behind the dam projects and other large public works derives from an extremely lucrative relationship between the major contractors and politicians. A dam may not have to make all that much sense if it generates sufficient commisso (commissions) for the right people.

Perhaps the best hope for the forests' survival is the growing recognition that they are more valuable when left standing than when cut. Charles Peters of the Institute of Economic Botany at the New York Botanical Garden recently published the results of a three-year study that calculated the market value of rubber and exotic produce like the Aguaje palm fruit that can be harvested from the Amazonian jungle. The study, which appeared in the British journal Nature, asserts that over time selling these products could yield more than twice the income of either cattle ranching or lumbering.

But if the burning of the forests goes on much longer, the damage may become irreversible. Long before the great rain forests are destroyed altogether, the impact of deforestation on climate could dramatically change the character of the area, lead to mass extinctions of plant and animal species, and leave Brazil's poor to endure even greater misery than they do now. The people of the rest of the world, no less than the Brazilians, need the Amazon as a functioning system, and in the end, this is more important than the issue of who owns the forest. The Amazon may run through South America, but the responsibility for saving the rain forests, as well as the reward for succeeding, belongs to everyone.

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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