Oscar Wilde once said, "We are all in the gutter, but some of us are looking at the stars." I've always liked the quote because it reminds us that when things look darkest, the odds of improvement are brightest.
When it comes to Goldman Sachs (NYSE:GS), I'd flip that quote around and say "When you're walking blindfolded on the edge of a roof, that gutter is just one step away."
Investing is a game of probabilities. You want to invest when the odds of winning outweigh the odds of losing. As Goldman sits on the very top pedestal of success, it's not hard to imagine that the odds of declining are being outweighed by the odds of uninterrupted euphoria. Here are two big reasons why.
1. Iceberg, dead ahead
I've belabored this point, but it's an important one: Goldman's success over the past year came from fixed-income trading. These profits aren't solely based on Goldman's talent, but on a yield curve sent from the banking gods above. Plenty of other banks, such as JPMorgan Chase (NYSE:JPM), Citigroup (NYSE:C), and Bank of America (NYSE:BAC), have enjoyed similar success in this area, but few notice because credit card and real estate losses have overshadowed windfall fixed-income profits.
Here's what's important: Short-term interest rates are as low as possible right now. They're at zero. They can only go up. When that happens, profit will start to get squeezed out of the fixed-income machine as short-term borrowing costs rise.
Some may counter that a rise in short-term rates will come only when the economy rebounds, and that rebound will be accompanied by gains in investment-banking revenue. This is true. I once believed that it was a bullish catalyst myself. But it's almost irrelevant when you consider that 48% of revenue last quarter came from the segment that houses fixed-income trading, versus just 7% from investment banking.
Bottom line: This is probably about as good as it gets for Goldman's main money machine. And just like with real estate in 2006, you should run for your life when it feels the best.
2. That faint scream you hear in the distance is Barney Frank getting angry
Consider this little nugget from the financial reform bill recently passed by the House of Representatives: "If the Board determines that propriety trading by a financial holding company subject to stricter standards poses an existing or foreseeable threat to the safety and soundness of such company or to the financial stability of the United States, the Board may prohibit such company from engaging in propriety trading."
To be fair, this language isn't catastrophic. I don't think looming regulation will have the teeth to truly undermine Wall Street's gravy train. But 81% of Goldman's revenue last quarter came from the "trading and principal investments" category. Are you willing to wager on a company that relies on a segment that politicians want to be able to arbitrarily "prohibit?" I'm not.
Random, vague arguments shot down
Don't agree with either of those? Still a Goldman fan? Maybe your arguments go something like this:
- Bullish argument No. 1: "Goldman trades at under 10 times 2010 earnings estimates. That's cheap!"
- Counter: It also came within spitting distance of blowing up just over a year ago, and its CFO bragged in the aftermath that "we've said very consistently that our business model remained the same." For a company with that much inherent risk, some might say 10 times earnings is highway robbery.
- Bullish argument No. 2: "If it's good enough for Warren Buffett, it's good enough for me!"
- Counter: Buffett owns preferred shares, and the common-share warrants Berkshire Hathaway (NYSE:BRK-A) received were scored for free. My guess is that Buffett wouldn't touch the common shares with a 10-foot pole.
- Bullish argument No. 3: "The government will never let Goldman fail."
- Counter: The government didn't let AIG (NYSE:AIG) fail either. Ask its common shareholders how that turned out.
Let's hear it from you
These reasons keep me far way from Goldman Sachs. But I want to know what you think. Agree with my pessimism? Think I'm an idiot? Share your thoughts either way in the poll below.
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