WHAT DOES THE GOLDMAN FALLOUT MEAN FOR STOCKS?

It’s looking like the banks perp walks couldn’t have started at a much worse time for Wall Street.  In mid-January financial reform discussions sparked a swift 10% bank decline, but as reform looked increasingly less likely the banks rallied and they rallied big.  Since the February bottom the banks surged 26%.  It was the largest rally without a 10% decline since last Summer.  How much of that rally was due to lax bank reform could play into the next move for bank stocks and with the way things are looking it wouldn’t be shocking if much of that rally was erased in the coming months.  Banks and the general market have been strenuously overbought for several weeks now, sentiment is wildly bullish and many of the positive catalysts (primarily earnings, an improving economy and lax financial regulation) have been priced into shares.

It was little reported on Friday, but stocks had already turned negative before the Goldman news hit the tape.  Google, Bank of America and GE all reported excellent quarters and all three sold-off on the news.  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 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.

Perhaps most alarming with regards to the Goldman news is the level of uncertainty it will create.   At first glance the reaction to the Goldman news looks excessive, but this could have widespread ramifications.  First, this lawsuit looks like a carefully crafted political move that will make 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.  JP Morgan 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 slam dunk.  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.  That’s good news for Main Street.  Harsh reform is necessary to protect us all from ever allowing these firms to put us in this position again.  Unfortunately, what’s good for Main Street is not always good for Wall Street.  I wouldn’t be surprised if bank stock puke all over themselves for several weeks until the dust settles.

In addition, there is severe risk of more perp walks.  This is eerily reminiscent of the Wall Street research perp walks following the many business scandals of the dotcom bubble.  In April of 2002 the market appeared to be stabilizing and had rallied 20%+ off its 2001 lows.  But then came the Sheriff of Wall Street.  Eliot Spitzer unleashed hell on the Wall Street banks when he sued several of the largest firms for conspiring to drive up prices.  Over the ensuing 5 months equities lost 25%.  The Goldman news is the first of what will likely be several perp walks.

Speaking of Eliot Spitzer, he has been very vocal in recent days about breaking up the big banks.  The Republicans certainly hate the too big to fail rule so it wouldn’t be shocking to see a resurgence in the Volcker Rule.  Goldman is so massively hated right now that any politician who stands in the way of strict bank regulation will likely face the consequences in November.  There is an almost frightening public outcry for harsh regulatory reform.  The Goldman news reverses what appeared like lax regulatory changes.

Making matters worse, this isn’t the last lawsuit.  The private lawsuits are likely to begin pouring in as small investors sue over potential negligence.  But it won’t stop there.  Several leaders including Connecticut Attorney General Blumenthal have said they are looking into any malicious actions.  The SEC also said that this is not the last of their investigations:

“We’re looking at a wide range of products.  If we see securities with similar profiles, we’ll look at them closely.”

Lastly, is the potential impact of Paulson & Co. redemptions.  The SEC was very clear that Paulson was not being charged, however, investors are fearful that Paulson’s $30B+ hedge funds could suffer redemptions that pressure markets.  The Paulson news alone drove gold prices down by 2% in Friday trade as investors feared the ramifications of any redemptions.

The reaction at Goldman certainly appears as though it is an overreaction considering the low penalty Goldman is likely to face, however, the contagion is likely the more important uncertainty at this point.  There is simply no telling how badly this could impact the banks and the broader market, but with stocks strenuously overbought and struggling to find a new bullish catalyst this couldn’t be happening at a worse time for the market.   I would urge investors to remember that the recovery is very much alive for now and a brief downturn in the market might actually be a good thing.  On the other hand, the urge to buy the dip in banks appears fraught with massive risks in my opinion and with this kind of uncertainty there is simply no reason to buy a sector that is just 3% off a new 52 week high and on the back of a smoking 26% rally….They say the trend is your friend until it bends.  Well, this bend looks like it could be particularly unfriendly.