Making Sense Of Meredith Whitney's Goldman Sachs Downgrade
Throughout the year, investment bank Goldman Sachs has served as a valuable proxy for the financial sector's overall recovery. Since the firm's share price bottomed out at $73.95 on March 9, Goldman has posted a couple of quarters of profitable earnings results based on its aggressive trading activities, managed to pay back its Troubled Asset Relief Program (TARP) loans, and got involved in the incoming tide of mergers and acquisitions deals. In the process, the bank risen in value by around 120 percent.
It's not overly far-fetched to suggest that Goldman Sachs has been responsible in some way for the recovery of the financial sector, since it has led the way for the most part.
It is therefore significant that Goldman Sachs has received its first downgrade of the year-to-date period, by none other than celebrity bearish analyst Meredith Whitney. As if to prove the point above, the downgrade sent most shares lower, even as Johnson & Johnson, a significant under-performer in recent months, posted better-than-expected earnings.
Whitney's comments, released by The Wall Street Journal blogger Matt Philips, make for poignant reading:
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 the shares should trade more or less in line with moves in the market.On some level, it almost seems as if Goldman is wary itself of its own rapacious performance this year. John Carney, an editor at business blog Business Insider, reported Monday that the bank is considering giving billions of dollars away at the end of the year to charity. Carney cited a former senior Goldman executive and a current managing director as saying they had both been urging recently for the firm to make hefty donations in order to deflect any flack over big bonus payments to employees.
Crunching The Correlations
But what is most interesting is Whitney's comment that shares in Goldman Sachs will begin to trade more or less in line with key index benchmarks. That's because for most of the past six months, Goldman Sachs has been doing exactly that. Since April, Goldman Sachs bears a much higher correlation to the S&P 500 Index than do other banks. With a correlation of 0.85 (a perfect correlation being 1), Goldman's stock price is pretty nearly entirely in tandem with the index versus correlations of around 0.7 or below for rival banks (excluding Morgan Stanley).
Goldman's relationship to the S&P has also been much higher than it is historically (which is around 0.65). In other words, Goldman has been leading the way for most other stocks. If, as Whitney thinks, the bank's valuation will now even out or rise at a slower rate, it's likely that the same will be true for many other banks, too.
That is not necessarily a good thing. For small banks, I have discussed before how big market swings are essential to their ability to raise capital. The massive liquidity has meant that the Federal Deposit Insurance Corporation (FDIC) has been able to sweep small bank bankruptcies quickly into the mouths of better-capitalized larger firms. Many banks and insurers right now are still chronically underfinanced.
In that light, if market conditions do begin settle down, we may be about to enter into a final (unexpected) phase of financial institution deleveraging and bankruptcies.