Markets around the world retreated on Friday following the announcement by the Securities and Exchange Commission (SEC) that Goldman Sachs had committed fraud in the issuance of a Collateralized Debt Obligation (CDO) during the credit bubble several years ago. Additionally, markets were also troubled by the belief that Greece is closer to a bailout from the International Monetary Fund (IMF) and European Union (EU) as interest by the private sector for Greek bonds waned.
The Dow Jones Industrial Average (DJIA) lost 125 points (1.13%) on Friday but still managed to extend its string of seven consecutive weeks of posting a weekly gain. The DJIA closed the week at 11,018.66 up 21.31 points (0.19%). The S&P 500 lost just over 19 points (-1.61%) on Friday closing the week down 2.24 points (-0.19%) and ending its consecutive weeks of posting a gain at six. For the year the DJIA is up 5.66% and the S&P 500 is up 6.91%. The MSCI EAFE (World) closed up 0.18% for the week (its fourth consecutive week of gains), and for the year this broad international index is up 2.01%.
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The news on Friday that the SEC was charging Goldman Sachs with fraud regarding a CDO issuance in 2007 sent the markets into an immediate pullback.
Goldman Sachs (GS) stock dropped $23.57 (12.7%) following the announcement. The markets’ reaction was much more focused on the word “fraud” rather than any potential economic harm to Goldman. The SEC did not rule out other firms being charged stating they would look closely at “similar deals” by other Wall Street firms that sold CDO’s.
The background behind the complaint is that Goldman Sachs was approached by hedge-fund manager John Paulson (no relation to Hank Paulson, President Bush’s Secretary of the Treasury) to construct a CDO comprising of sub-prime mortgages only. CDO’s are essentially a large collection of mortgages that are combined into one package that are supposed to act much like a bond. Paulson’s belief was that the sub-prime market was going to fail and he wanted to have Goldman create a financial product that he could then short (bet against). Paulson would make money if the sub-prime CDO lost money. Goldman brought in a third-party bond firm, ACA Management, and (according to the SEC complaint) worked with Paulson to design the CDO which Goldman then went out and sold to investors. The central core of the complaint is not that Goldman improperly worked with Paulson and ACA (neither firm has been charged), but rather Goldman failed to notify buyers of the CDO that another investor (Paulson) had an active hand in designing the CDO in which that investor had a contrary position. The SEC is also alleging that Goldman did not make clear to ACA that Paulson was going to be short (bet against) the CDO.
As a precursor of things to come, Germany is apparently weighing its own investigation after that country was forced to bail out banks because of significant losses in US CDO investments including the CDO cited in the complaint.
Goldman Sachs strongly denies any wrongdoing in the case saying that “we did not structure a portfolio that was designed to lose money.” Goldman also contends that any sophisticated investor could have looked at the underlying mortgages within the CDO and conducted their own analysis and not rely only on the opinions offered by ACA. Additionally, Goldman contends that it actually took a long position (a bet that the CDO would rise in value) in the CDO and ultimately lost $90 million on their own money. Back in 2007, investors were buying billions of dollars of CDO’s and Paulson’s position had no assurance of success. It will now be up to the courts to decide the merits of the case, but the stock markets have reacted immediately by shunning all risky or riskier assets. As this story unfolds, do not be surprised if the facts of this case change.
Greece’s situation this past week was just more of the same. The private markets are showing no interest in buying Greece’s debt, the EU and IMF are pledging support for a bailout without offering any details, and the Greek’s continue to complain about the austerity measures taken by the government. With private investors moving away from supporting Greece, it is virtually certain that Greece will have to receive a bailout from the IMF and the EU. This should help stabilize the situation for now, however, it does not address the basic issue that Greece is spending more than it can afford and the EU will be challenged by this imbalance. The long-term impact on the EU is very uncertain at this time. The Euro lost $0.0015 on Friday closing the week at $1.3495. For the week the Euro lost $0.011 marking its second consecutive week of negative returns against the US Dollar.
The Rest of the Market
With all the fears of fraud and failure circulating through the markets on Friday, Treasuries and bonds appreciated in value as investors sought the safety of these traditional investments.
The yield on the 10-year Treasury dropped 0.11% for the week closing at 3.7703%. Just two weeks ago the yield briefly pushed above 4%. The Dow Jones Corporate Bond Index also gained and closed the week at 109.01 (+0.71). This is the first time since March 19th that the index closed above 109. While bonds have moved up over the past week, a break above 109.38 will overcome resistance in place since late last year and be a bullish signal for the bond market.
Commodities across the board fell on the Goldman news including gold. The most actively traded June delivery contract priced gold at $1136.30 down $23.40 (-2%). The general consensus among traders was that short-term gold contracts are considered volatile and therefore a more risky asset. Possibly adding a bit of nervousness to gold traders is the knowledge that at the end of 2009, John Paulson’s hedge-fund was the largest institutional holder of the gold SPDR (GLD) with 31.5 million shares.
Oil fell about 2% in value with Brent crude closing at $85.93 a barrel. There is some speculation that Goldman may be forced to liquidate some of its bets on rising oil prices to raise financial reserves stemming from the SEC investigation.
China reported on Friday that their 1st Quarter, 2010, Gross Domestic Product increased at a strong 11.9% raising concerns about the negative effects of an overheated economy. The Chinese did announce they were increasing down payment requirements on real estate, however, the real issue remains on hold and that is whether or not the Chinese will allow the yuan to appreciate against global currencies. The current valuation of the yuan is pegged against the US Dollar and is believed to be undervalued by currency experts. A cheap yuan makes Chinese goods less expensive to the US and the rest of the world while making foreign products sold in China more expensive.
Looking Ahead
The markets made a decisive turn away from all assets perceived as risky on Friday as investors worried about Goldman Sachs.
I believe that this was unwarranted because the real economic impact of the credit crisis has already been realized by the markets. One bank analyst from Barclays even speculated that the announcement of the Goldman law suit was timed to help propel the Financial Reform Bill through Congress. I do not know if this is true, but this is not the time to overreact to Friday’s news. If the trends turn defensive, then so will I. I will tell you if and when that happens and adjust portfolios as appropriate.
There has been no change in my favored sectors and they are Real Estate, Consumer Discretionary, Information Technology, Financials and Materials. Small and Mid Cap stocks continue to be favored over Large Cap stocks—a relationship that has been in place since the markets began their turnaround a year ago. The New York Stock Exchange Bullish Percent (NYSEBP) fell 0.15 on Friday to close the week at 79.55. For the week the NYSEBP was up 1.83.
While International Equities have returned to a favored status, emphasis is on the non-developed parts of the world. The top four countries on a relative strength basis are Turkey, Thailand, South Korea and Brazil. Thailand had a tough week with the political turmoil taking place in that country, but remains ranked fourth of the 33 countries and indexes in my iShare International Relative Strength matrix. I am watching developments in Thailand closely.
I still prefer US Corporate Intermediate-term Bonds and International bonds in the fixed-income area.
As always, if you have any specific questions on your portfolio or wish to talk to me, please do not hesitate to call.
Paul L. Merritt, MBA, CRPC® Principal NTrust Wealth Management
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