financial indictments: suppose the worst is true?

The Goldman indictment

This morning’s Wall Street Journal has an article in it which, while neatly summarizing the SEC case against Goldman Sachs, also states that the SEC is investigating other investment/commercial banks for similar possible violations.  (By the way, the WSJ is also running an opinion column arguing that the indictment is a mostly political move, and more a “water pistol” than a “smoking gun.”)

how true? how pervasive?

Stock market reaction around the world to the Goldman indictment has been immediate and negative, giving rise to the question:  what happens to the overall stock market if the worst turns out to be true?

I would define “worst” as meaning

–that ultimately most big bank are brought up on charges similar to Goldman’s (a JPM indictment would be particularly bad) and

–that legislation is enacted that restricts the future profit-making activities of the banking sector.

My guess is that convictions and fines would be much less important for the fate of the financial sector on Wall Street than a loss of trust in the companies and a shrunken future stream of profits.

how I handicap the issue

1.  Start by observing that the financial sector makes up 16.5% of the S&P 500.  Just to pick a number out of the air, let’s say that if the combination of social stigma and legislation that limits growth were factored into today’s prices, that would take a third off the sector’s market capitalization.  That’s too much, in my opinion, but let’s just say.

This would amount to a fall in the S&P of 5.5%.

2.  We might reasonably argue that the transactions in question didn’t do much overall economic good and might have actually been damaging.  That is to say, they moved money from the pockets of one set of brokerage clients to another, but provided no real other economic benefit.  To the degree that they helped the housing bubble to expand, they might have been harmful.

If so, requiring fuller disclosure or otherwise making them harder to do wouldn’t really hamper economic growth.

3.  If we lived in the simplified world that academics inhabit, and if we knew 1. and 2. for certain, investors would probably make a very swift adjustment in the prices of financial firms (and no others), dropping the S&P to 1130 or so in a couple of days.  As far as the S&P is concerned, that would be the end of the matter.

In the real world, we don’t know many things for sure, however.

uncertainty has consequences

Uncertainty has two main consequences:

–although I think that whacking a third of the value of all financials is much too much, the market–an emotional beast–could overreact

–declines are almost never isolated to a single sector.  There are always relative value arbitrageurs, who will regard financials as cheap and sell other sectors to get the money to buy them.  This process means the entire market, not just the financials, will go down.

two conclusions

The first is that while the SEC action may not exactly be a tempest in a teapot, I don’t see that it is anywhere near important enough to undermine the case that we’re in a bull market–or to be anything more than a temporary setback to the market’s advance.  Ultimately, the simple-minded 5%-6% drop in the S&P will likely prove correct.  But we probably get there by a roundabout route.

My guess is also that financials won’t regain in the near future the stock market leadership role they have played so far this year.  IT is my candidate for its replacement, but that’s been my position for a long while.

the timing of the case?

The Goldman indictment comes at a delicate point for the market.  After declining in late January-early February, the S&P has been marching upward very consistently, to the point last week where it had achieved almost all the gains that even bullish market commentators had predicted for the full year.  The index was also flirting with its (technically/psychologically important) levels just before the Lehman collapse in September 2008.  So it was arguably due for some sort of correction.

To some degree, then, the Goldman indictment should be seen as the trigger, or excuse, for something the market was going to do anyway, rather than the cause.  But the correction will likely be deeper and more prolonged than it would be otherwise.  Maybe we have a repeat of the January-February decline.  One positive sign I’ll be looking for would be that other sectors would perk back up even though financials languish.

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