Goldman Sachs May Beat the Rap, but Market Could Still Take a Beating

Last Updated Apr 22, 2010 1:34 AM EDT

The case against Goldman Sachs (GS) seems flimsy, as I argued in a recent post. That doesn't mean that the lawsuit filed by the Securities and Exchange Commission will have only a muted and fleeting effect. The damage - to the company, its stock and the broad market - could be severe and long lasting.

Even if Goldman did nothing illegal and will be judged that way, the company's reputation and share price are likely to suffer as the case drags on. The same goes for other banks, although not to the same extent, as investors worry about which of the usual suspects will be on the wrong end of an SEC lawsuit next.

Because banks are in the line of fire and the potential impact on their business is more palpable, their stocks stand to suffer the most, but the market in general is at risk for reasons that are somewhat obscure.

The fraud allegations against Goldman leave cynics on Wall Street spoiled for choice. Those who see no merit in the SEC suit may view the agency as doing the dirty work of a left-leaning presidential administration eager to bring investment banks to heel.

On the other side, probably in the majority, are those who view Wall Street as a place where you have no chance of coming out ahead unless you know someone or, better yet, are someone. Cynics of this variety have felt this way forever, or at least since Hillary Clinton's remarkable success trading cattle futures came to light.

The cynics had such low expectations to begin with that the Goldman case will have little effect on them. The more severe fallout could result from disillusionment among the true believers. These are the many ordinary investors who trust the markets to be honest, efficient places that give the little guy a fair chance to share the wealth generated by corporate America.

They seem to have begun losing their faith well before the Goldman Sachs scandal broke. A recent post by Philip Davis, a blogger on the Seeking Alpha website, highlights several signs that small investors have substantially given the yearlong rally in stocks a miss.

The most glaring piece of evidence is the persistent dearth of money flowing into equity mutual funds. Davis also cites high concentrations of volume from activities like program trading and from trading in a handful of financial service stocks that have soared in the last year. Just six issues produce more than one-fourth of the shares changing hands on the New York Stock Exchange in some weeks, he says.

"The recent gains [in the stock market] have come with only marginal support from traditional long investors," he writes. "Wall Street trading desks and the relatively new breed of high-frequency traders have been fueling the rest."

It's not unusual for the pros to come back into stocks ahead of the public after a long bear market. The reticence to hop on board the new bull run is often a sign, in fact, that the rally will have some legs.

This time around, though, the amateurs seem to be staying away for longer than usual. Maybe they're still afraid of losing money after the ups and downs of the last three years. If they decide - rightly or wrongly - that a big investment bank like Goldman Sachs is gaming the system, a significant number may not come back at all.