Yes, the merits of the SEC’s case are questionable, and Goldman Sachs (GS) could likely win a court battle, and easily afford any fine imposed.
So what? Much of the damage could be done before that is resolved, even assuming markets were rational. Here’s what should concern us about this case:
Summary: Timing and Context Are Awful
The timing of the scandal could hardly be worse.
The current rally is in trouble
- Fundamental Problems: With the EU debt crisis once again unraveling and China getting more serious about slowing its growth, it has plenty of headwinds
- Given the above, and that stocks are already at 52 week highs, markets were already selling off after the good earnings announcements Friday BEFORE the Goldman Sachs fraud charges were announced, and, as we warned, is likely to be sold off on anything less than stellar earnings results.
- Inter-market indicators are also bearish:
- Commodities: gold and oil have been forming the beginnings of downtrends (relative to the safer ones) for over a week. Prior to the last stock pullback in late January, gold and oil also were well into their corrections before stocks even got started.
- Forex: Over the past weeks, the #1 safety currency, the Japanese yen, has been gaining ground against all major currencies despite the lack of significant positive Japanese economic news, and the aftermath of Japanese exporters' yen buying spurt was over. Thus the yen’s rise can only be due to forex traders seeking defensive forex plays and unwinding riskier carry trades in higher yielding currencies.
- The financial sector has lead markets in and out of rallies. This scandal is a likely direct hit on the sector, which is already challenged by widespread but hidden solvency issues and a new round of mortgage resets and spikes in nonperforming real estate loans. Now the sector must also contend with a newly hostile regulatory environment, reduced earnings, soaring legal costs and liabilities. These new threats may ultimately prove manageable, but in the short term they could create tremendous uncertainty for an already stressed sector and stock market.
With concerns that a good earnings season is now already priced in, the Goldman Sachs scandal could easily catalyze a pullback that many expected soon anyway.
The Rally is Winded Already
Stocks had already turned negative before the Goldman news hit the tape. Google (GOOG), Bank of America (BAC) and GE all reported excellent quarters and all three sold-off on the news. No huge surprise, as we have been warning readers about this potential ‘sell-the-news’ reaction given that:
- stocks are at or near 52 week highs worldwide
- the danger of the EU crisis sparking a new credit contagion
We saw the same thing occur last quarter when investors were eager to front-run the earnings news, but were disappointed to find out that the news was already priced in by the time the reports were released. That resulted in the brief 9% decline that laid the foundation for the current move higher. At this point, a very good earnings season is more than common knowledge and the recent surge in equities is evidence of that. Investors are already selling the earnings news so any positive catalyst for equities will likely come from other sources. There is none on the scene.
The Scandal Threatens Much of The Financial Sector
Perhaps most alarming with regards to the Goldman news is the level of uncertainty it will create, given the potentially widespread ramifications.
- Banks Become Political Football-Will Get Kicked: This lawsuit plays into the hands of Washington, which is seeking financial reform far more stringent than bank investors had been expecting. President Obama was out Friday saying that he will veto any bill that does not contain derivatives reform. That will hurt financials and stocks in general. The big banks have lead global asset markets down and up over the past years, so any drop in their fortunes is likely to be shared by asset markets worldwide.
- Revenue Damage: JP Morgan (JPM) CEO Jamie Dimon has previously mentioned that this portion of the bill would cost the bank between $500MM – $700MM. The Goldman lawsuit appears to make derivatives reform a certainty. This would likely shave billions in easy profits from total S&P 500 earnings. The President has also expressed a willingness to drop the $50B bailout fund. Mr. Obama is flexing his muscles now and looking to slam thru his second big bill in a matter of months, as he seeks to salvage the Democrat’s political fortunes in the coming US elections midterm elections.
- Legal Costs: Likely the larger, more dangerous uncertainty. There is real risk of lawsuit contagion here, given the numbers of private and public entities that have been hurt over the past years by the derivatives driven maelstrom. Both private and other governmental lawsuits are likely to begin pouring in as small investors, state, and local governments seek what they can.
It’s unclear how large the liability is for the banks and the broader market that has followed the financial sector.
Goldman: The Catalyst For End of Rally for Banks, Stocks, Other Risk Assets?
With equities overbought and struggling to find a new bullish catalyst, and commodities and forex markets already beginning to turn, it’s difficult to see how risk assets can avoid a pullback at this time given the downside risks posed by the EU alone, never mind the considerable new risks posed by the Goldman Sachs scandal to the critical financial sector-which may be the last straw for the risk rally.
As we’ve noted repeatedly, after a lull in 2009, the banks are already staring down the barrel at a new wave of mortgage resets of a magnitude that when last seen set off the subprime crisis and ultimately the current recession. Bank health is challenged as is, without even considering the effects from the EU and Goldman Sachs fiascoes.
In sum, it’s possible the scandal is containable. However, it could so easily snowball into something much worse, compounded by an EU debt crisis that is not going away.
Disclosure: No Positions