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Why Goldman Sachs shares can fall to $105

23 April 2012

Goldman Sachs may be the demonised “vampire squid” of Wall Street but also unquestionably the bellwether bank in global capital markets and securities underwriting. So I was naturally concerned that its earnings were down 23 per cent, even though it beat Street EPS whisper numbers in the 3.60 range. David Viniar’s Press conference was a downer. The merger and acquisition pipeline is in the doghouse.

Moody’s has put the investment bank’s debt under credit review. The partner exodus does not portend that all is hunky dory in the kingdom of Dark Star. The Volcker Rule, Dodd Frank and Obama’s crusade against oil speculators (guillotine the black gold gnomes of NYMEX, Mr President, as a French Finance Minister once warned those who bet against franc fort in the 1990’s?) are a sword of Damocles on history’s most fabulous proprietary trading franchise since the Medici Bank financed the Popes, doges and kings of the Florentine and Venetian Renaissance. So, in a sense, like Lorenzo di Medici, Lloyd Blankfein really does God’s work!

The dividend hike was a plus but the plunge in ROE to a dismal 12 per cent is sadly, structural FICC (almost 60 per cent of revenue) was a disappointment (but not surprising given 30 per cent plunge in VAR) even though equities execution (block trading) was up seven per cent. Jim O’Neill’s GSAM was fine (Hooray, Big Jim!) My conclusion? The capital markets are still nowhere near Xanadu and Shangri-La. It is impossible for me to trust metrics like valuation multiples or price/book value as long as I expect ROE to remain in a mediocre 10-14 per cent range in 2012. This means the only lodestar of value for Goldman Sachs is its tangible book value at $125 and Goldman should not trade at tangible book value as long as market share/EPS growth/ROE metrics do not improve. In essence, Goldman Sachs faces its nemesis at $125.

I expect debt capital markets will boost investment banking, though Europe and China underwriting and commodities face hard times. This is not exactly the Panglossian best of all possible worlds in the investment banking cycle and the malign ghosts of Abacus have still not been exorcised by the SEC. It is tough for me to estimate Goldman’s 2013 earnings power, as FICC revenues were down despite the post LTRO plunge in asset vols and credit spreads. Sadly, FICC is no longer a gold mine, even lagged Citi to add insult to injury. (OMG, Citi. Come on guys! Where is Zeus on 85 Whitehall?).

So where is value in Goldman? Not here at almost 10 times a potential $12 current year EPS. The outflows from GSAM and the Volcker Rule impact on merchant banking are not good and most of the good news on costs is done. Basle Three, Finreg reform, China and Club Med sovereign debt risk mean Goldman, in my view, trades lower, possibly as low as 105. So I would sell Goldman Sachs at 117 for a 105 one month target. The world of 20 per cent ROE and King Midas FICC is now as dead as Nineveh and Carthage. Goldman is a short here and a double short at $125 (TBV). The gods of asymmetric risk smile on this in my view, as an admirer and trader of GS ever since it went public back in the Stone Age in 1999.

Morgan Stanley’s investment banking and FICC revenues were up an impressive 30 per cent and equities, forex and rates flow business have also clearly benefited from the new management team led by James Gorman. The problem is the dismal new economics of investment banking and the mediocre 8-10 per cent ROE business. The imminent Moodys downgrade and European political risk limits any real upside in the shares, though I will sell October put options on MS if the investment bank shares fall to 17. The ideal trading range for MS, in my view is to buy at 16 and sell at 20.

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