The SEC’s action against Goldman Sachs is just the kind of dramatic and unforeseen event that could stop the equity market’s strong rally in its tracks. By chance the day before yesterday’s SEC announcement hit the news wires, I spent some time discussing the state of the markets with Richard Oldfield, a highly regarded investment manager who runs the successful boutique firm Oldfield Partners, and among other things sits on the Investment Committee for Oxford University’s endowment. (He is also the author of a splendidly readable book, entitled Simple But Not Easy, which explains in plain language some of the home truths about the business of investment management that you won’t hear from most practitioners).
Discussing how far and how fast the markets have turned round over the past 12 months, Richard noted how whereas being bullish a year ago was patently a minority view, more recently it has become mainstream, even if volumes remain light by historical standards. Although you can justify the market’s current levels on valuation grounds, given the positive surprises about earnings and economic recovery that continue to come out of the United States, we are reaching a stage where markets become vulnerable to an adverse movement in sentiment. With Wall Street already looking somewhat overbought on technical grounds, it might not take much, he thought, to stop the rally.
Among other telltale indicators that Richard tracks, he has learnt to keep a close eye on the Bullish/Bearish adviser sentiment index tracked by the technical analysts at Investors Intelligence. When the proposition of bullish advisers exceeds 50% it is a classic warning signal. “I have ignored it in the past and usually come to regret it” , he told me. With the most recent reading at 49% bullishness in the US adviser community against just 18% bearishness, we are approaching just such a point when it leaves the market vulnerable to an unexpected piece of bad news. Barely 24 hours later we have just such a potentially damaging story hitting the headlines.
Why could today’s Goldman Sachs story be that news? Partly of course because Goldman is the pre-eminent investment bank in the world. If the SEC succeeds in proving a case against them for its part in the subprime mortgage scandal, it could well be the trigger for actions against other participants as well. It also signals the strength of the political imperative for the authorities to be seen to taking action against those who were prominently involved in the subprime disaster.
More importantly, try as hard as it might, Goldman has been unable to refute convincingly the unsavoury suggestion that it was effectively playing both sides of the trade as the subprime mortgage market collapsed – helping to create the CDOs that hedge fund managers such as Jim Paulsen wanted to short and then selling them to others of its own clients. The apparent conflict of interest is not only unseemly but potentially, if proved, highly damaging to Goldman’s brand name and franchise.
The 12% drop in the investment bank’s share price yesterday is not an encouraging omen, implying as it does that the market is all too aware of the potentially adverse implications of the SEC’s action. Needless to say, immediate market reactions are often wildly overstated and it may be that Goldman will be able to fight back successfully and contain the damage as we move forward. If the share price recovers quickly, the story may well disappear and the market can continue its upward momentum. I have certainly learnt many times the importance of not over-reacting to dramatic sounding market news, especially when as now equities are due a pause after a strong run.
Nevertheless, to my mind this has all the makings of a red flag which could in time turn out to have wider market implications, of the kind that Richard Oldfield raised as a possibility. Against a still positive outlook for equities, a note of caution is called for.
