Whitney’s Goldman Downgrade: Why She Did It

Meredith Whitney downgraded Goldman Sachs (GS) from ‘buy’ to ‘neutral’ today. Previously, Goldman had been her only buy recommended stock, all of the others rated neutral or ‘sell.’ Why did she do it?

FT Alphaville has the answer:

We are downgrading shares of Goldman Sachs to Neutral from Buy after over a 34% run in price since their second quarter results. At $190, shares have exceeded our $ 186 12-month price target, and we believe upside could be limited over the medium term. Specifically, we invoke a "why be greedy" rationale with such a stunning move in shares over such a short period of time. From here, we believe upside to GS’ shares is more of a "market call" and that shares should trade more or less in line with moves in the market.

In essence, Whitney is making a call based on valuation more than fundamentals. She believes Goldman’s fundamentals still remain good. After all, Lehman (LEHMQ.PK) and Bear Stearns are gone – so competition is less. But, the stock has run up too much to warrant buying at these levels. This makes sense if you look at how Goldman’s stock has fared over the last two years.

Goldman Sachs is trading at its highest level since May 2008, well before Lehman failed. So I do think taking profits is warranted. That said, should you sell now or wait for the price action to dictate when you sell? I am saying cut exposure now but Jeffrey Saut of Raymond James uses a quote to make a compelling case for waiting for the stock to roll over so as to not sell early (hat tip Barry Ritholtz).

The absolute price of a stock is unimportant. It is the direction of price movement which counts.

During major sustained advances in stock prices, which usually occupy from five to seven years of each decade, the investor can complacently hold a list of stocks which are currently unpredictable. He doesn’t worry about the top because he knows he is never going to sell at the top. He knows that the chances are overwhelming in favor of the assumption that he will get far better prices by waiting until after the top is passed and a probable reversal in trend can be identified than he will ever get by attempting to anticipate the top, and get out on the nose.

In my own experience the largest profits we have ever taken have come from stocks purchased while they were making a new high in a market which was also momentarily expecting the top. As I have already pointed out the absolute price of a stock is unimportant. It is the direction of the price movement that counts. It is always probable, but never certain, that the direction of the price movement will continue. Soon after it reverses is time enough to sell. You should sell when you wish you had sold sooner, never when you think the top has arrived. That way you will never get the very best price – by hindsight your individual transactions will never look daring. But some of your profits will be large; and your losses should be quite small. That is all that is necessary for a satisfactory, enriching investment performance.

“Stock Profits Without Forecasting,” by Edgar S. Genstein

This makes sense if you don’t have a price target for the stock you buy. But, on the whole, I say pick an exit point when you buy a stock and stick to that target. This is what Whitney is doing. And this is essentially what I have recommended for selling equities based on a Jeremy Grantham S&P target.

As for banks stocks, the whole sector is through the roof and I certainly do not believe the fundamentals warrant this as I laid out last week. Goldman is a broker-dealer and a bank in name-only. Its model has not changed, so it is operating in an environment far more inviting than its big bank cousins like Bank of America (BAC) and Wells Fargo (WFC).

So while Goldman and Morgan Stanley (MS) are looking at better prospects there are numerous obstacles to for banks. Two articles I linked to yesterday point out some of the headwinds.

First, from the Financial Times:

A surge in fixed-income underwriting opportunities during the quarter is expected to boost revenues not just at Goldman, but also the investment banking divisions of JPMorgan Chase (JPM), which reports on Wednesday, and Bank of America, which announces results on Friday.

However, the non-investment bank operations of JPMorgan and BofA will be hit by loan losses in the commercial area as well as the consumer area, says Richard Bove, an analyst at Rochdale Securities.

“They will have to go back to increasing the size of their reserves,” Mr. Bove adds.

“This could result in losses for the quarter and into next year.”

Notice how this article distinguishes between proprietary trading and broker-dealer activities on the one hand and traditional banking operations on the other. The credit cycle is still in a downswing and this will hurt banks. But there are also other forces at work. Marshall Auerback pointed out a Bloomberg article to me regarding the huge book of business the big banks do as mortgage servicers and how accounting rules there look unfavorable going forward.

The four biggest U.S. banks by assets may have to take writedowns on $55 billion of mortgage- collection contracts after marking them up by $11 billion in the second quarter, casting a shadow over earnings.

Bank of America Corp., JPMorgan Chase & Co., Citigroup Inc. and Wells Fargo & Co. wrote up the value of the contracts, known as mortgage-servicing rights or MSRs, by 26 percent in the quarter as mortgage rates climbed by about 0.35 percentage point. Net gains on the contracts added more than $1 billion to Wells Fargo’s record earnings in the quarter and $1 billion to JPMorgan’s first-quarter profit.

Mortgage rates fell about 0.26 percentage point in the third quarter, according to Freddie Mac (FRE), and servicing costs are rising, meaning the four banks, which handle collections on more than $5.9 trillion of U.S. mortgages, may face writedowns.

Add these to my other concerns in commercial real estate, deposit insurance payments, credit card losses, loss of government subsidies, and a flattening yield curve and you see an environment in which bank stocks should underperform the market.

The long and short is bank stocks have run up too much too quickly. Now is the time to lighten up on them. This is true whether you are talking about Goldman, which is going to earn a lot of money, or the likes of Bank of America, which faces a more challenging environment.

Comments

[waf76]

I would agree the banks have run up quickly and it could be wise to lighten up. However, much like what you point out in your article, it is best to wait for a reversal in trend, which quite frankly has yet to occur as evidenced by the November calls on XLF.

2009 Oct 13 01:52 PM

[everyothercatstaken]

Nice article Mr. Harrison. I agree with your conclusion to lighten up on financials about now. While there might be a few more nice upside surprises on Q3 earnings, I would expect an ensueing sell-off as investors worry about increased loan loss provisions in Q4.

And thank your for the terrific Genstein share and your attention to valuation of MSRs as expertly explained by Moore in the Bloombert article. The bottom line which financial sector investors should understand is to forsee the efficacy of the bank's hedging strategies to offset any losses in MSR valuations. To which I say "Good luck!" I've seen a number of major servicers get it wrong fairly consistently, which is obviously based on missing their interest rate projections; hence misdirecting their hedge strategies. A couple of larger servicing banks, though, seem to nail it positively most of the time.

Again, thank you!

2009 Oct 14 02:11 PM