A cranky hedge fund manager reviews a GS report

Barry Ritholtz at The Big Picture reprints the key part of a Floyd Norris blog entry that is apparently behind the NY Times pay firewall. A hedge fund manager sent Mr. Norris a copy of a recent Goldman Sachs report, "The Quant Liquidity Report". The fund manager also included some nasty annotations of the report's arguments. It's hard to choose the best of the seven annotations; here are two that made me laugh:

Goldman Sachs: "We do not believe that current prices reflect fundamental values.” Manager: "Based on what? The very models that failed you last week?"

Goldman Sachs: "In the coming weeks, we will continue to analyze this extraordinary period. We will also re-evaluate and re-prioritize our research agenda in light of recent events. Stay tuned. As we continue to study these events, we hope to gain additional insights that will help us avoid similar problems in the future.” Manager: "We don’t know what happened to us or what we’re going to do about it, but we really, really, really don’t want to admit that the fundamental premise of our business is fatally flawed and shut down, so we’ll come up with something."

It seems to me--though I'm eager to read more from experts in the area--that this recent blow-up was quite similar to the blow-up of Long Term Capital Management: asset prices which are almost always negatively correlated suddenly became postively correlated. Lots of undervalued stocks--like Bank of America, after announcing a fine quarter and a 14% dividend hike, fell in price to yield a whopping 5.4%--became still more undervalued.

When the quants rework their models, it seems as though it will be easy to build in a "trip wire" so that they can recognize, extremely quickly, when conditions have become very unusual. But what will they do with that recognition? Other than deleverage, which undermines--as the cranky hedge fund manager notes above--the very heart of their strategy?