Eugene Linden
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Lastest Musing
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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THETORTUREDLAND

AN EPIC LANDSCAPE STEEPED IN TRAGEDY, SIBERIA SUFFERED GRIEVOUSLY UNDER COMMUNISM. NOW THE WORLD'S CAPITALISTS COVET ITS VAST RICHES
BY EUGENE LINDEN/YAKUTSK


Monday, Sep. 04, 1995
Siberia has come to mean a land of exile, and the place easily fulfills its reputation as a metaphor for death and deprivation. Even at the peak of midsummer, a soul-chilling fog blows in off the Arctic Ocean and across the mossy tundra, muting the midnight sun above the ghostly remains of a slave-labor camp. The mist settles like a shroud over broken grave markers and bits of wooden barracks siding bleached as gray as the bones of the dead that still protrude through the earth in places. Throughout Siberia, more than 20 million perished in Stalin's Gulag.

Siberia is much, much more, however, than the locus of past political evil. For every person sent unwillingly to exile in its arctic wastelands, many others came to hunt, trap, fish, log or mine. The harsh life drove many back, but others stayed, captivated by the sublime beauty of earth's greatest northern landscape. Vitali Menshikov, an oceanographer by training, came to the Kamchatka peninsula in the Far East 27 years ago. He has returned to Leningrad only once; instead, he has used his vacations to take expeditions--61 so far--on ski and foot through this breathtaking land of volcanoes, geysers, forests, lakes and meadows.

Kurilskoye Lake, in the southern part of the peninsula, offers a glimpse of a paradise lost elsewhere on the planet. Sockeye salmon choke the mouths of streams, huge brown bears and their cubs feed on cloudberries in the surrounding sun-dappled meadows, while a giant stellar sea eagle rides the thermals on the flanks of one of the volcanoes ringing the lake. Boulders made of porous volcanic rock float at the edge of the lake, seemingly defying gravity. George Schaller, the renowned and famously dour American wildlife biologist, who is visiting the region to study brown bears, looks out over the natural bounty, and a broad smile splits his face. "Bears never had it so good," he says. "Isn't it nice to go somewhere and find good news?"

No one would disagree, but, as Schaller knows, the comforting image of Siberia as the world's last pristine northern frontier also misses the mark. Kamchatka is but a tiny piece of Siberia, and elsewhere this continent-size region has been grievously wounded, and continues to be wounded today. "Let's say you decide to get away from it all in Siberia," says Alexei Yablokov, Russia's leading environmentalist and once President Boris Yeltsin's top adviser on ecology. "You travel up the Yenisey River toward the Arctic. You look across the empty tundra and think you are alone in nature, miles upon miles from the nearest person, and you decide to stretch out on the riverbank. Unfortunately, you are lying in sands contaminated by plutonium from three upstream nuclear reactors whose radioactive wastes have been carelessly dumped for over 40 years."

Under 70 years of communist rule, Siberia became not only a place of punishment but also a punished place, and nuclear trauma was but one of the tortures visited on the land. Possibly the largest single source of air pollution in the world is a complex of smelters in Norilsk in central Siberia; it pumps 2 million tons of sulfur, along with heavy metals and other poisons, into the air each year, contributing heavily to a noxious arctic haze that plagues residents of the northern latitudes as far away as Canada. Siberian industrial emissions contribute heavily to the threat of global warming, which in turn may come back to burn the region. Nearly two-thirds of the region lies atop permafrost. Climate models estimate that even a small temperature rise globally would be exaggerated in the north, and could melt the upper parts of the permafrost, turning huge areas of Siberia into mush and toppling the thousands of Soviet-era buildings erected on stilts sunk into the ice. The price for ridding Siberia of ugly Stalinist architecture, however, would be that the meltdown would release enormous amounts of methane, exacerbating climate change.

The perverse genius of the Soviet system was its ability to maximize the problems associated with modern industrial societies without producing many of the benefits. Perhaps never has so vast a territory been so despoiled so rapidly. Now the question is whether the capitalism of the new Russia will save Siberia and its reeling ecosystems or finish them off. The stakes could not be higher, involving the future of earth's grandest northern landscape and the political stability of a nuclear superpower.

The expanse and the magnitudes of Siberia are mesmerizing. Officially Siberia is the territory east of the Ural Mountains and west of the Russian Far East, which includes the maritime provinces of Khabarovsk and Primorski on the Pacific coast; however, convention has labeled as Siberia all Russian lands east of the Urals--an area that covers more than 5 million sq. mi. Within these boundaries are nearly the entire lengths of four of the longest rivers on earth--the Yenisey, the Ob, the Lena and the Amur, which constitutes most of Siberia's border with China. Yakutia, now designated the Sakha Republic and the largest of Siberia's dozens of political divisions, is more than seven times the size of California. Magadan is three times; Krasnoyarsk is nearly six Californias. The entire region is frigid in winter. Oimyakon in Yakutia is often cited as the coldest inhabited settlement on earth, with winter temperatures dropping to -94 degrees F. The summers are so short that plants rush wildly to take advantage of the brief heat and light. In some parts of Kamchatka, grasses grow up to 3 in. a day. During that season, bugs proliferate and clouds of mosquitoes, dubbed gnusy (the vile ones), can turn brief strolls into interludes with the vampires.

The vast expanses contain natural oddities and wonders. In the far north, climate and physics conspire to defy common sense. Lakes wander up to 10 ft. a year as their waters accumulate summer heat and melt the edges of their permafrost boundaries. Summer melting of the upper layers of the permafrost also allows leaves frozen since the Pleistocene era to return to their slow-motion decay. For years scientists were puzzled by the age of methane gases released from arctic lakes, which radiocarbon dating revealed to be more than 10,000 years old. Mammoths that strode the earth in millenniums past are still discovered almost perfectly preserved in the permafrost meat locker. Many believe the present-day Yakutian horse is itself a throwback to the era of the ice ages. With such conflation of past and present, it seems almost reasonable when one Russian ecologist, Sergei Zimov, suggests that a "Pleistocene Park" could be established using the DNA magic of its Jurassic movie counterpart. Some scientists believe the mammoth could be brought back by inserting readily available, naturally refrigerated mammoth DNA into an elephant embryo.

The natural wonders of Siberia inspire the imagination of scientists and tourists; its vast riches beckon others. The taiga, the word used to describe the region's enormous forests, in particular has captured the attention of both foreigners and Russians. Japan, Korea and the U.S. covet the rich forests of southern Siberia. The Russian government sees its timber as a quick source of cash to prop up an economy that continues to flounder. Fearful of an economic collapse that might once again bring to power a hostile, nuclear-armed totalitarian regime, the U.S. is trying to promote the responsible exploitation of the region's resources, in part through a series of agreements on trade and technology negotiated by U.S. Vice President Al Gore and Russian Prime Minister Victor Chernomyrdin. Argues Gore: "It is unlikely that you are going to see an area larger than the U.S. ruled off limits to forestry by a nation struggling for hard currency to make the transition to democracy and free markets. If that is so, doing it the right way rather than the wrong way is an advantage."

Forests, however, are just one item in Siberia's bulging portfolio of natural resources. Soviet exploitation managed to poison and degrade 35,000 sq. mi. of the vast republic, but that only scratched the surface of its mineral wealth. Bob Logan, an economist at the University of Alaska, has made trips to Yakutia to study the region's economic prospects, which he describes as "staggering." As much as 20% of the territory is known to have oil and gas deposits that could make it the Saudi Arabia of the north. The area is one of the world's leading sources of diamonds, and Logan notes that 80% of the gold produced there comes from riverbeds and ancient gravel banks, an indication that the republic has barely begun to tap its underground veins.

The world looks upon all these resources and salivates. Texaco, Exxon, Amoco, Norsk Hydro and other transnational oil companies are setting up joint ventures to tap into the enormous oil and gas reserves scattered through Siberia, including the Timan Pechora basin above the Arctic Circle (where the recoverable reserves are estimated at nearly 4 billion bbl.). Canadian, American and other Western mining companies are prospecting for gold and other minerals. Norwegian and Japanese interests are negotiating to increase shipping between Europe and Asia by way of arctic waters north of Siberia.

Russia wants to realize income from the region's resources as fast as possible. Russian environmentalists, however, say they need time to put in environmental safeguards. Buying time for one purpose will inevitably come at the expense of the other. Environmentalists have reason to be wary. In recent years, the decline in law and order in the former U.S.S.R. has led to a tremendous increase in poaching, particularly of the Amur tiger. Tigers once roamed Russia from the Caspian Sea to the Pacific and from the Chinese border to the Arctic. Now only the Amur subspecies remains, hemmed in to the forests of Primorski province by the Pacific Ocean and the Chinese border.

No one knows how many tigers are left, but today Primorski province is estimated to have between 180 and 200, down from 350 in 1990. Vasili Solkin, the head of the Russian environmental group Zov Taigi, which means Roar of the Taiga, estimates that in 1993 alone, 75 to 80 tigers were killed, representing more than one-quarter of the remaining population. When traditional East Asian apothecaries ran out of sources for tiger skin and bones, which are used as medicine, among the places to which they turned for new supplies was Siberia. At the same time enforcement efforts collapsed as budgets for ranger patrols disappeared and corruption flourished, driven by stagnant salaries and hyperinflation.

Nevertheless, market chaos and international attention appear to have alleviated the crisis somewhat. In 1994 poaching began to drop dramatically. Solkin says that last year between 25 and 30 tigers were killed, about the level of poaching during the Soviet period. He argues that as many as 40% of the tigers killed in the early 1990s were never sold because of the anarchic marketplace and fear of being caught, and notes that drug dealers who dabbled in the illegal wildlife trade have backed off because trouble over a tiger skin could jeopardize an established channel for moving drugs.

The tiger-poaching crisis also showed the degree to which Russians can control an environmental problem when they have the resources. Russia has many dedicated game rangers who were thrown out of work by the collapse of the U.S.S.R. A group of international organizations led by American environmental investigator Steven Galster cobbled together the funding to put rangers back to work, and the newly formed patrols have been in the field since January 1994. The so-called Amba patrols have been working to disrupt poachers and their trade networks. Amba was given a boost this summer when Prime Minister Chernomyrdin issued a decree calling for a national strategy to protect tigers and their habitat. Unfortunately, protecting the forests that are home to tigers and other creatures is one environmental problem that is literally out of control.

According to environmentalist Yablokov, the problem can be traced to the waning days of the U.S.S.R. when the parliament, seeking to circumvent the power of the central government, passed laws that gave local authorities enormous power over resources, as well as the implied right to contravene federal regulations protecting ecosystems. Nonetheless, it was thought that the strong central government could still maintain the balance of power. Then came the August 1991 attempted coup against President Mikhail Gorbachev and the rapid unraveling of Soviet authority. With no federal checks on local power, according to Yablokov, these laws became the legal basis for the devastation of natural resources. Local politicians are quite happy with this situation because it gives them a free hand to turn a profit.

Loggers take pains to lend a pretense of legality to their ventures, but loopholes and lack of enforcement make it easy to bend the law in ingenious and profitable ways. In the district of Khabarovsk, the government tried to impose environmental controls on logging but allowed officials to exempt concessions smaller than 5,000 acres from strict review. Alexander Kulikov, chairman of the Khabarovsk Wildlife Foundation, says that just before they leave office, local officials hand out dozens of concessions, often to friends and relatives. He says that in the Khor River watershed, a region of about 12,000 sq. mi., more than 90 forest enterprises are operating with almost no oversight from the government. "What is the solution?" asks an exasperated Yablokov. "Chechnya? Send troops to Novosibirsk?"

Vice President Gore's answer is to send U.S. experts. Were U.S. involvement confined to sound environmental practices, American expertise might actually help. But U.S. initiatives are a tangle promoting contradictory programs: the U.S. is sponsoring a project to protect biodiversity in the Khor River watershed while at the same time giving grants to study the feasibility of logging in the region. Moreover, critics point out that the U.S. has a less than thrilling record preserving its own forests. The U.S. has less than 5% of its ancient forests and suffers from a timber shortage; Russia has roughly 25% of its original forests intact.

Kulikov is dubious about these American initiatives. He fears that sound forestry practices will be sacrificed early on because they have not yet proved profitable anywhere in the region. And even in the best of circumstances, U.S. solutions may not work. Says Yuri Du nishenko, the vice chairman of Kha barovsk's Wildlife Research Institute: "We have different soils and a much harsher climate than the U.S. What works in the U.S. may not work here."

A consequence of the various forestry initiatives may be a surge in anti-Western feeling, the very thing Gore hopes to prevent. While communism ravaged the land, the Soviet commissars did leave a powerful legacy: a conviction that forests and other resources are owned by all Russians and not some favored elite. Consequently, the wholesale sell-off of Siberia has aroused great bitterness among Russians. "You own us now," says an official sarcastically. Ordinary people are frustrated by corrupt courts, by self-dealing and favoritism and by confiscatory taxes that force honest businesspeople to become cheaters. Increasingly, their ire is directed against the new order. When asked to name the greatest threat to Russia's wildlife, Vladimir Shetinin, the head of the Amba patrols, responds with one word: "Democracy." It is a widely shared opinion.

While the liquidation of forests preoccupies Siberia's south, the northern regions are obsessed with the dream of better transportation links to the outside world. In giant Yakutia, officials speak of the benefits of a sea route across the top of the continent that will open their territories. They long to be free of extortionate transportation mafias that saddle the region with what may be the highest shipping costs in the world. The fees are so high that merchants in Cherski often find it more economical to import food products from Alaska than buy from elsewhere in Russia--and Alaska has the highest food prices in the U.S. The northern passage has been used by the military and some Russian shippers for decades. According to Norwegian economist Trond Ramsland, who has analyzed the costs and benefits of the northern sea route, it can provide a link between East Asia and Europe, vastly shorter and cheaper than the present voyage through the Suez Canal. Ramsland argues that shippers could move goods at an average cost of $35 a ton, as much as $10 a ton cheaper and 11 days faster than shipping through the Suez.

Since the northern sea route was opened to commercial foreign traffic in 1992, however, only one vessel has made the complete trip. Big insurers are loath to underwrite these ventures, given the severity of the northern weather and uncertainty over Russia's ability to keep the route open. Indeed, instead of charging minimal fees to grab market share, the Russian authority responsible for the sea route set the administration fees at $6 a ton, eating up most of the savings that might come from taking the route.

Market pressures and the demands of the Russian economy may eventually make the route financially viable. That is a moment many environmentalists dread. Tankers are likely to be the chief users of the route, and oil spills could do unimaginable harm to arctic ecosystems. Dorothy Childers of Greenpeace points out that the sea route follows the easiest path through the polar ice, the same path taken by migratory birds and marine mammals. Will development be worth the risk?

Yakutia, which suffered horribly from radioactive fallout from nuclear tests and chemical pollution during the Soviet era, has shown itself to be farsighted in dealing with some environmental issues. The delta of the Lena River lies atop reserves of oil and gas. It is also a diverse ecosystem created in part by the meeting of the great tectonic plates that lie under North America and Eurasia. Mindful of Siberia's sorry record of leaky oil pipelines and catastrophic spills, the republic was hesitant to open this vulnerable area to drilling. Says Vasili Alekseev, the Minister of Ecology: "Since there is no truly clean technology to extract those reserves, we felt it better to create the Lena Delta Biosphere Reserve and protect the area. Perhaps in 50 or 100 years there will be a new technology for extraction, and then, if we still need oil and gas, future generations can decide whether to review the reserve's status." This is a perspective that Yakutia's arctic neighbors in Alaska might consider, as oil and gas interests clamor to open the great Arctic National Wildlife Refuge for drilling.

South and East of Yakutia, jutting 750 miles into the Pacific Ocean, lies the Kamchatka peninsula, the only major piece of the former Soviet Union to survive decades of communism relatively unscathed. A peninsula larger than North and South Korea combined, Kamchatka has stunning treasures to preserve: active volcanoes, wild rivers, hot springs, floating boulders and other natural wonders. It was spared the forced march of Soviet-style economic development. Because of its strategic location, it was sealed off from foreigners and most Russians for 65 years. With only 450,000 people, most of whom live in and around the capital, Petropavlovsk, the region is probably the largest pristine northern territory in the world. "We are aware that there are not many untouched places like Kamchatka in the world," says Boris Sinchenko, first vice governor of the Kamchatka region administration. "We have looked at what mining has done elsewhere, and we will not go the route of Magadan and Yakutia." Nor does he see Alaska as a model, noting that it has been "spoiled" by mining and oil development. Instead he sees future growth coming from fishing, tourism and some mining in tightly controlled circumstances. The authorities in Kamchatka know how to act decisively. In 1994, after a binge of poaching and sport hunting halved the number of brown bears in just five years, wildlife officials clamped down on the use of helicopters during hunts. The bear population has stabilized at around 5,000.

Kamchatka, however, must contend with the same pressures as the rest of Russia. Sinchenko admits that the government is under great pressure to replace the subsidies and remittances that ended with the collapse of the Soviet Union. Ecologists are worried that the local government will finance those expenses on the back of the environment by opening Kamchatka's rich mineral reserves to development. David Gordon of the Pacific Environment Resources Center, a California-based environmental group that has focused its efforts on threats to Siberia, notes that even now an American-Russian joint venture is preparing to mine gold in an area near two salmon rivers that was once intended to be part of a reserve. He fears that the way in which the project is being rammed through--without proper environmental review--sets a troubling precedent. Kamchatka has more than 300 other potential mine sites, many of them near existing or proposed nature reserves.

During the Soviet era, the government used coercion, monetary inducements and subsidies to populate Siberia because of the region's strategic importance. Now that the subsidies have disappeared, people are leaving in search of jobs elsewhere. Of the Kamchatka peninsula's 450,000 people, 320,000 live in two cities. The rest of the peninsula has less than one person per 4 sq. km. But still, people are leaving. The peninsula has lost 40,000 people, nearly 10% of its population, since 1985. In Yakutia, the Arctic city of Cherski, near the mouth of the Kolyma River above the Arctic Circle, has lost nearly half its population in just the past two years. (Recently, though, it has had a reported influx of Russian mafia hit men who use the town as a "riverbed"--slang for a hiding place--to cool off between assassinations.)

The outflow from Siberia helps put to rest one of the most enduring myths about the region--that it is virtually empty. The number of humans is in fact low in absolute terms. Currently Siberia has 30 million inhabitants, with the largest concentrations in cities like Novosibirsk (pop. 1.4 million) and Vladivostok (pop. 640,000). The entire Russian Far East, covering 2.4 million sq. mi., has 8 million people, less than the population of Moscow. But Siberia is not empty; it is not even underpopulated.

Perhaps the most vivid example of the complex demographics comes from Primorski province in the heart of a vast and pristine watershed. When told that the outside world views their forests as empty, four Udege hunters laugh uproariously. They argue that too many people are already using the forest. A study shows that only half the watershed's nearly 5,000 sq. mi. of forest produces enough sable, deer and elk to support hunters. And a single tribal hunter must roam a territory as large as 75 sq. mi.--about the size of the Caribbean island of Aruba--to trap enough fur and hunt enough meat to live on. That allowance is calculated to provide wildlife the space and opportunity to reproduce and maintain stable populations. The Bikin Valley has 47 hunters licensed to hunt full time in the territory, which already presses the limits of the available productive forests. Add to that 90 other permitted hunters who enter their grounds to hunt for meat and, as the region opens up, sport hunters and poachers, and the ecological calculus for the survival of species goes completely awry.

Still, the small human populations of Primorski, Kamchatka, Khabarovsk, Yakutia and the other republics and provinces of Siberia are a luxury shared by few other places on earth. They give the region the opportunity to restore the ecological balance. And while it is tempting to draw parallels between the ecological standards of Siberia and those of most of the Third World, there is a tremendous body of environmental expertise and activism among the Russian people. For every profiteer who would make a quick buck off the fire sale of Siberia's assets, there are many who decry the theft of national patrimony. What Russia does not have is time and money, and the paradoxical nature of its plight is that it must sell its resources in order to stabilize its economy and thus create a democracy in which rules can be enforced regulating the exploitation of those resources.

As of now many major corporations are still poised on the sidelines. Russia's tax laws and the mercurial nature of its legal system still discourage major investment. For instance, some months after Yakutia passed its first constitution, Russia imposed a number of changes on the document. Says economist Logan: "Nobody is going to make investments looking 25 or 30 years into the future in a country where changes can be imposed at the constitutional level by fiat." Nevertheless, Russia is struggling to resolve these problems, and when it does, the real land rush will begin.

When that moment comes, neither the problems nor the solutions will be Russia's alone. Those who are pushing the clanking machines toward the forests' edge and those who will profit from the Siberian harvest need to be responsible and restrained. The high technology and efficiency of the West can help reduce rampant waste and pollution, but they can also speed destruction.

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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