The Headline May Be Goldman Sachs

Richard E. Haskell, Sr.


Inside Signature Update


• The Market – Trouble at Goldman More About Headlines Than News

• The Economy – 1st Quarter 2010 Earnings Reports

• The Takeaway – Become Focused on Quality and Healthy Balance Sheets


THE MARKET – Trouble at Goldman More About Headlines Than News

News of the Securities Exchange Commission’s (SEC) filings against Goldman Sachs (GS) dominated the financial news in mid-April 2010, but the real news was the surge in strong earnings reports from some of the nation’s most important corporations. Nonetheless, Goldman’s issues are substantial, and the impact on the firm many see as Wall Street’s premier investment banker may take years to sort out; not to mention the negative consequences the firm’s actions may have had on investors and the market. The firm’s association with John Paulson (Paulson and Co.) and Fabrice Tourre and the allowance of questionable trading and disclosure practices is troublesome.

The potential fallout for the financial services sector, stemming from the SEC’s charges against Goldman, is massive. Allegations and charges of abusive practices and fraud in Goldman’s hedge fund and CDO (collateralized debt obligation) operations will undoubtedly shake up much of Wall Street’s hierarchy, undermine investor confidence and rejuvenate legislative efforts to reign in the nation’s investment banking complex. But maybe that’s exactly what legislators and regulators had in mind when the SEC’s charges were announced.

There is growing concern that SEC leadership, the White House and Congressional Democrats may have timed the filing of charges with renewed legislative efforts focused on increasing federal investment banking regulation with the release of quarterly earnings from some of Wall Streets most important firms. Without attempting to discount the potential severity of Goldman’s alleged actions, Representative Darrell Issa (R-CA) called on SEC Chair Mary Schapiro to provide documentation of "any sort of prearrangement, coordination, direction from, or advance notice" between the SEC and the Obama administration or congressional Democrats. Within minutes of the SEC’s filing of charges, the internet and media were awash with reports and “spin”; including Democratic National Committee (DNC) fundraising ads aimed at making the most of the controversy.

Financial services industry regulatory reform efforts, led by Senate Banking Committee Chairman Chris Dodd (D-Conn) and Representative Barney Frank (D- Mass), began to make the national news again in a well orchestrated campaign aimed at legislators and voters, the timing of which was simply too coincidental with the SEC’s announcements to be mere happenstance. While it may not matter in the long run, it does suggest that the SEC, under Mary Schapiro’s leadership, may not be as independent as is intended.

For long-term market observers, this has an all-too-familiar ring to it and is beginning to feel similar to the scrutiny the SEC focused towards Drexel Burnham Lambert in the late 1980’s. Some will recall that Drexel, the Goldman Sachs of the 1980’s, was a leader in the underwriting of debt instruments known as “junk bonds”. These bonds were packaged and sold in an effort to provide less credit worthy firms with debt financing in such a way that it was difficult for many investors to comprehend their true origins, but they carried the promise of returns that made them extremely attractive to the markets. In affect, “junk bonds” were to the 1980’s what derivatives, CDO’s and CDS’s became to the 2000’s.

Wall Street’s “junk bond king”, Michael Milken, engineered Drexel’s underwriting and trading of these instruments and generated extraordinary profits for the firm. In 1988, the SEC brought separate charges against Milken and Drexel, culminating in a 10-year prison sentence for Milken and Drexel’s demise. As an interesting aside, it’s unlikely Milken would have faced prosecution in today’s environment where the risks, rewards and structures of the capital markets are more widely understood; Milken resurfaced in the late 1990’s to become one of Wall Street’s wealthiest and most philanthropic personalities.

The losses resulting from the Drexel/Milken scandal amounted to tens of billions of dollars and rattled the financial services industry, but brought about little change in the structure and marketing of complex debt instruments. In truth, the debt markets opening up in the 1980’s led to the more complex derivatives market under scrutiny today.

While the regulation of the derivatives market and its complicated instruments are necessary, the demonization of the industry and some of its important firms and leaders, is not. The Obama administration and Democratic leadership continue to lecture Wall Street and risk undermining the nation’s economic recovery. What appears to have been forgotten is that it takes investment capital to create jobs; which capital comes through personal savings, corporate profits and the capital creation efforts of the nation’s investment banking firms, of which Goldman Sachs is an important leader.

By November 2010 the political import of the investment capital/jobs creation relationship may become acute for members of the House of Representatives and incumbent Senators seeking re-election. Many Americans will cast their votes for political hopefuls they view as able to see past the rhetoric. As former US President Bill Clinton asserted, “it’s the economy, stupid.”

It’s time for our nation’s elected officials, governmental agencies, and media representatives to recognize that headlines and well timed campaigns focused on anything other than capital and job creation only serve to expose their biases. In the end, Americans spend and vote; the less they’re able to do of the former makes them that much more interested in exercising their right to affect change with the latter.


THE ECONOMY – 1st Quarter 2010 Earnings Reports

As the US markets continued to move past 11,000 points on the DOW in April 2010, investors and policy makers should focus their attention on earnings reports and away from distracting sideshows. Many expect that the gains of the last 12-13 months (almost 70% for the DOW) aren’t likely to be repeated any time soon and that the easier part of the recovery may be behind the markets. Moving forward, market gains are likely to face periodic headwinds and will continue to rely on growth in revenues and earnings.

With unemployment still in excess of 9%, the nation’s attention must continue to focus on earnings and investment. Economists will point out that only businesses create jobs and they only do so towards the latter part of a recovery, after there has been sufficient growth in revenues and profits to justify investing in growth to support the increasing demands of the market place.

As further proof of the strength of the current economic recovery, many of the nation’s most important firms have announced impressive revenue and earnings growth for the 1st Quarter 2010 compared to the same period in 2009. The following are a small sampling of those reported most recently:

• Apple posted profits of $3.07 billion compared with $1.62 billion.
• Illinois Tool Works posted $294 million in net profits versus $8.1 million.
• Citigroup’s earnings climbed to $4.4 billion from $1.59 billion.
• Yahoo’s profits increased to $310 million from $118 million.
• United HealthCare’s earnings rose to $1.19 billion from $984 million.
• Goldman Sachs posted a 91% increase to $3.46 billion from $1.81 billion.
• Union Pacific’s earnings jumped 43% to $516 million from $362 million.
  
  In the midst of the 1st Quarter 2010 earnings reporting season, the S&P 500 crossed the important 1,200 mark and the DOW fortified its position north of 11,000. These levels will only be supported by continued earnings growth as briefly discussed in the April 6, 2010 issue of Signature Update (Earnings Expectations and Tobin’s Q).
  
  Other earnings reports of interest are Harley Davidson and Coach; important brands when considering consumer preferences and higher-end consumption patterns. Though neither firm reported record earnings, both beat analyst expectations and reported both earnings and revenue improvements over prior periods.
  
  Though there will certainly be earnings disappointments as well, the trend towards higher revenues and earnings offers important evidence that the economy is headed in the right direction. Economist and former Assistant Secretary of Commerce, Dr. Quincy Krosby, points out that the markets may experience a “tug of war” in coming months as sovereign debt issues and likely interest rate increases become important factors. But even Krosby warns against betting on US small business and consumers, suggesting that businesses and consumer will always find a way to prosper.
  
  Among the “head winds” that may lie ahead are near-certain tax increases for consumers and increased borrowing costs for businesses. As unwelcome as these may be, it’s possible that they’ll come in moderation. If President Obama keeps his campaign commitment to lower corporate business tax rates, the aggregate impact on the economy could be negligible; sadly campaign promises are much like devalued currency – they’re hard to spend and most often buy very little.
  
  Though investors may have already gathered the easier gains from the recovery, the US markets are likely to trend higher on improving revenues and earnings. Once businesses have recovered sufficiently to round out inventories and replace outdated equipment, the employment market can expect to experience a sufficient rebound to move the economy into a post-recession/post-recovery period of sustainable growth and market gains.
  
  
  
  THE TAKEAWAY – Become Focused on Quality and Healthy Balance Sheets

• Financial stocks may have seen their near term highs as legislative and regulatory efforts are likely to increase costs and reduce revenues. Additionally, the federal government’s sale of Citigroup shares in the open markets may put downward pressure on banking stocks as a whole.

• Though most healthcare and pharmaceutical firms posted increased revenues and profits for the 1st Quarter 2010, many lowered their guidance for future quarters on concerns over potentially negative consequences of the recently passed healthcare legislation.

• Investors should become increasingly focused on quality issues and healthy balance sheets to avoid possible market headwinds. Dividend paying firms with limited debt may become increasingly attractive as the recovery begins to mature.

• Voters across the country are presenting an anti-encumbant attitude that should be concerning to elected officials of both parties. Jobs are more likely to win voter loyalty than party affiliation in the November elections.
  
  
  
  
  Signature Update is offered by Richard Haskell, CEO of Signature Management, LLC