Why the Market Won't Trade Straight Down From Here

| About: Goldman Sachs (GS)

Goldman Sachs (NYSE:<a href='http://seekingalpha.com/symbol/GS' title='Goldman Sachs Group Inc.'>GS</a>)Financial markets were facing extreme selling Friday after Goldman Sachs (GS) was charged with fraud by the SEC for marketing debt products which were essentially designed to fail. According to the accusation, John Paulson assisted Goldman in creating Collateralized Debt Obligations (CDO) which allowed investors to capture positive cash flow by essentially “insuring” mortgage securities. Paulson who took the other side of the trade ended up getting paid huge sums when the mortgage market eventually fell apart.

The SEC charge brings up an interesting philosophical debate. How much liability should Goldman (or for that matter Paulson) have for creating investment products that buyers were clamoring to own – even if it was clear that the end result would be major losses for clients of Goldman.

Keep in mind the years leading up to 2007. Real estate prices continued to climb and optimism reigned supreme. Middle class, lower class, and even upper class consumers were all but assured that the way to build permanent, sustainable wealth was to own real estate – a LOT of real estate. Since land has a fixed supply (how many times did we hear the wisecrack “they’re not making any MORE of it”?) investors expected the price of homes, land, condos and office properties to continue to rise ad-infinitum.

Leverage was strongly encouraged because when prices do nothing but rise, leverage works in the buyers favor. So Wall Street was all-too-happy to create opportunities for non-creditworthy buyers to get in the home of their dreams. It all made financial sense because if the buyer eventually defaulted, the value of the property would have risen to more than make up for the loss on the loan. And typically, owners would simply refinance, borrowing more on the value of the property – and use the money for paying the loan or other discretionary purchases

Owning a home could actually become a self-funding venture.

Caveat Emptor?

So during this manic time period, investor appetite for mortgages naturally increased. Think about it… When buying mortgage securities, you were essentially loaning money to purchase properties that continued to appreciate in value. The collateral was becoming more valuable, meaning that every day your loan became more secure.

In this environment, it’s hard to understand why Goldman wouldn’t offer mortgage products to investors who were begging for more supply. If you’ve read John Paulson’s book The Greatest Trade Ever (a great read I might add) you would see just how strong the demand was for these securities and how the momentum fed on itself.

I guess my main question is – was Goldman really wrong to sell ill-fated mortgage securities to willing and experienced professionals? I know there is more to the story than this, but the bottom line is that these CDOs weren’t being sold to individual investors who knew nothing about the market. They were being sold to pension funds, endowments, hedge funds – to institutions managed by professionals who should have researched what they were buying.

Part of the SEC’s accusation centers around the fact that Paulson & Co. helped to pick out the individual mortgages or baskets that went into the CDO securities. This is certainly something that should have been disclosed to buyers – if the seller has access to non-public information that the buyer cannot uncover, then the playing field is tilted.

But what worries me is the moral hazard that is emerging in the financial markets. More and more, it seems that we expect gains to be privatized (meaning if companies MAKE money, they get to keep it), but losses are socialized (the government steps in to make losers whole).

What ever happened to a fair market where willing buyers and willing sellers met to exchange goods (be they industrial, agricultural or financial goods)? If I make a trade and lose money, the responsibility is mine. My job is to cut my losses, learn a lesson from the mistake, and move on to bigger and better trades. The same should be true of all market participants, and if you or I buy products that we don’t understand, then we shouldn’t be involved in that market in the first place!

But I digress…

Where To From Here

My suspicion is that the market won’t completely fall apart at this juncture in the game. The bulls have been entirely too strong and we have been conditioned to “buy the dips” (even though there have been precious few dips to buy recently). Investors with any capital on the sidelines have largely been kicking themselves for not participating and promising to put their capital to work the next time we get a correction.

So this buying pressure brought on by classical conditioning will likely stabilize the market in the short-term. So I wouldn’t bet the farm on a major short position Monday morning at the open.

However… I DO think that over the next two months we will have a significant negative move in the market and give up a good portion of recent gains in speculative positions. Even though a lawsuit against Goldman has very little to do with most industrial, technical, medical or retail stocks, the political risk introduced into the market could have the effect of decreasing the multiple investors are willing to pay on stocks across the board.

Currently, the majority of short positions have been closed as traders have been punished for any bearish bets. Short sellers usually help to stabilize falling markets because they represent pent up buying pressure as they buy to cover their positions and collect their profits. With these participants largely out of the market, the decline could turn out to be much more severe.

Prices are currently at levels that imply a full, robust recovery, so any change in this expectation will cause “long and leveraged” managers to re-think their positions. So after an initial buying period, don’t be surprised to see the market head south in a hurry.

I’ll be using the next week to brush up on my short watch list and look for names that have the most risk, the highest multiples, and investors with the strongest confidence. While many of these names will be tough to short (due to the strong price momentum), watching the charts carefully for good entry points, and managing risk with stop orders could turn out to be a very profitable endeavor. I have felt like the first quarter didn’t offer too many opportunities for large profits, but the climate today makes me excited about the new opportunity for traders willing to play both the long and the short side of the market.

Goldman Sachs (<a href='http://seekingalpha.com/symbol/GS' title='Goldman Sachs Group Inc.'>GS</a>)

Full Disclosure: Author does not have a position in GS

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