Goldman Sachs

With Goldman Sachs (ticker: GS) being sued by the Securities and Exchange Commission (SEC) for fraud over subprime CDO’s gone bad, the potential is there to see a measure of risk taken off the table the table over the next few days.

And as we’ve seen, when risk comes off the dollar gets bought.

We certainly saw that on Friday as the greenback advanced against the better-yielding euro, pound, Australian and New Zealand dollars while the S&P declined by 1.6%. Meanwhile, GS lost over $10 billion of market cap and financial shares declined an aggregate 3.8%. As always, commodities like oil fell and Treasuries advanced while traders grew more skittish.

Going forward, there’s now an element of uncertainty which didn’t exist prior to the disclosure. For one thing, it’s doubtful that this particular transaction was the only one of its kind that Goldman was involved with. Indeed, the British and German governments gave early indications that they plan to do a bit of digging themselves, and we already know that Goldman helped Greece hid the extent of its deficits with interest rate and currency swaps.

As a trader, it’s always important to look at what happened to the markets under similar circumstances. The problem here is that basically, as far as I can tell, no one has ever traded through an SEC fraud allegation of one of the world’s biggest investment banks while the global economy is at the early stages of recovering from a devastating credit crisis.

That’s why a simplification of the situation sometimes the best approach. To my way of thinking, if it looks like garbage and it smells like garbage then it must be garbage, which means that we’re likely to see a continuation of what happened last Friday at least over the next few days.

The problems related to GS aren’t the only ones which could cause stocks to take a tumble (and cause the dollar to advance). For one, China is making some moves to pressure its growing real estate bubble by requiring higher down payments and limiting loan amounts for non owner-occupied homes and apartments. Prices in the big city coastal areas are already several multiples above what even a two income household can afford to carry.

Still, in the longer term, there’s every reason to believe that investors will go long once they spot a bargain. It’s highly unlikely that Goldman is going to come out of this with anything more than a few bruises and some blows to its pride. People are not going to permanently stop doing business with them.  It does look bad now, and it is, but Goldman is not going out of business and the banking system is not going to seize up as it did after Lehman collapsed.

To become a really great trader takes more than smarts; it also requires you to make a cold, hard assessment of your strengths and weaknesses. You have to know exactly what you can and cannot do, trade to what you can, and not let your weakness dominate. The following lesson from Warren Buffett should be instructive in this regard.

Back in September of 2008, Goldman Sachs was looking for a “stamp of approval” so the company turned to probably the most famous and respected trader in the world, Warren Buffett. Goldman agreed to pay Mr. Buffett an extraordinary rate of interest-10% a year on $5 billion worth of preferred shares.  Buffett however wasn’t satisfied with that-he insisted on obtaining warrants which gave him the right to purchase Goldman stock for $115 per share, about where the stock was trading at the time.  In fact, Buffett never would have gotten into the Goldman investment in the first place without receiving the warrants-they were a “kicker” on the deal that he absolutely insisted upon.

Buffett probably could have negotiated a better price for the warrants because remember, it was Goldman who came looking for Buffett, not the other way around. Here’s where it gets interesting.

As Mr. Buffett has often said, he’s a long term investor with no ability whatsoever to trade in the short term. But he doesn’t let his inability to trade in the short term (his weakness) get in the way of his long term trading ability (his strength). Within three months of making the $115/share deal, Goldman was trading at about $52, making the warrants virtually worthless because no one is going to exercise the right to buy something at a loss. Aside from that, the deal looked even worse because remember that Buffett never would have bought the preferreds without the warrants in the first place.

When Goldman sank to $52, Warren Buffett didn’t turn tail and run by cashing in his preferreds because they now were attached to worthless warrants. In other words, he didn’t let himself get stopped out of the trade. Why? Because Warren Buffett was trading to his strength-the long term; he wasn’t going to let a short term fluctuation (which he admittedly has no ability to trade anyway) interfere with what he knows to be his greatest abilities.

In the meantime, Goldman closed at about $162 on Friday, meaning that Mr. Buffett is up around 40% on those warrants. And he’s still getting paid 10% a year on his preferred shares.

What would have made this trade even more difficult for mere mortals is that his positions were played out all over the financial press. And although I don’t have the exact quotes, I distinctly remember an article on CNBC which postulated that the “old boy had lost his touch” when Goldman’s price was declining. Meanwhile, Buffett had warned during an interview that it always was possible (one could argue probable) that he might get things very wrong in he short term.

So, what are the trading lessons here? First, you always want to trade to your strengths. If you have a system that works for you, stick with it. If you don’t, get one that does. Second, if Warren Buffett is one of the world’s great traders, and he sometimes has to hold a trade at a loss in order to eventually become profitable, chances are that you and I are going to have to be able to do the same thing. Most importantly, don’t get into a trade if you aren’t willing to hold a loss and don’t get into a trade if having a loss is going to make you believe that your original opinion was wrong to the point where it forces you to close your position. Those are pretty high standards-it probably means that you’re going to have less trades but it also probably means that the ones you have will be that much more successful.

On a different subject, here’s why stabilization in U.S. housing along with rising equity markets are so vital to a global economic recovery.

U.S. homes prices lead the way because they’re the ultimate collateral for the $11 trillion of US home mortgage debt, a significant share of which is held in the form of asset-backed securities by foreigners. Some economists are now saying that prices appear to be stabilizing (even though they could drift a bit lower into 2010) due to the decline of inventory overhang being brought about by the sharp drop in the number of new homes coming onto the market.

Rising stock markets are a major contributor to global business activity in two major ways. First, rising share prices will lead to increased household wealth and spending. We’re seeing this happen in China, where a 50% increase in stock markets has led the way to a 30% rise in consumption on the part of consumers. Second, as the market value of existing corporate assets (proxied by stock prices) relative to their replacement costs grow, it will make economic sense for business to make new capital investment, a significant driver of GDP.

One factor that is likely to remain as a huge driver of improving equity prices is the continued policy of monetary expansion. During a Town Hall interview with PBS on Sunday night, Fed Chairman Bernanke retained the dovish outlook displayed in his Congressional testimony last week by implying that the emergency liquidity programs will be unwound only when there is certainty of economic recovery while reiterating his expectation of low inflationary pressure over the next couple of years. He also forecasted unemployment above 10% and suggested that the first half 2010 may not mark the peak jobless rate, meaning that at this time the Fed is not expecting to raise borrowing costs until well into 2010 and possibly later.

Range Bound Markets

In case you haven’t noticed, things have been kind of range bound over the past month or so for the major currency pairs as well as the S&P 500. Understanding why that’s happening  will lead you into the next trend when conditions change, setting up a good trade.

For many traders, this kind of back and forth movement is much harder to trade than when prices are moving in a trend. I posted a long trade on GBP/JPY and AUD/JPY May 26 on twitter that returned about 1000 pips by June 1 but on June 8 I said “it isn’t a good time to trade currencies due to the lack of a strong fundamental driver.”

This is exactly where trend-following trading systems fail, because there’s no indicator to tell you that markets will go range bound. You have to rely on fundamentals (and your instinct) in order to make a judgment call like that.

While there are a number of arguments that can be made regarding why this is occurring now, for my money it’s the fundamental state of the economy which is dictating the action here at the end of the second quarter. Simply put, it appears that a depression has been avoided and that the recession is slowly coming to an end.  But what also appears to be the case is that the economy will remain sluggish for a period far beyond the end of the recession as the unemployment rate edges inexorably towards 10% (or higher).

This is the view of none other than Nouriel Roubini, who believes that 2010 will “fell like a recession” even if the economy is technically out of one. Meanwhile, San Francisco Federal Reserve Bank President Janet Yellen believes that although the recession is likely to end later in 2009, a “frustratingly slow” recovery marked by continued high unemployment is likely to follow.

“I am not optimistic that the economy will spring back to normal anytime soon,” she said on Tuesday during a scheduled speech. “I’m more concerned that we will be tempted to tighten policy too soon, thereby aborting recovery.”

Unemployment will “remain painfully high for several more years,” she said, which obviously points to more troubled loans for the banks in both residential and commercial mortgages.

She also implied that policy makers will leave the Fed Funds Rate near zero for the next several years, saying that such a policy is “not outside the realm of possibility,” in the press conference which followed her remarks.

Here’s something interesting I found on Bloomberg regarding a Goldman Sachs currency trade:

“Goldman Sachs exited a bet that the Canadian dollar would strengthen versus the Mexican peso,” the article said. “Goldman entered the trade on June 8 and stands to lose about 5% including the cost of carry after being “stopped out” when the peso traded beyond 11.40 per Canadian dollar yesterday.”

This just goes to show that even the best of the best can lose when the fundamentals are too unclear or when they fail to provide a strong impetus.

On To The NFP

The much smaller loss of jobs last month (-345K vs. -504K previous) was accompanied by an increase to 9.4% (from 8.9%) in the unemployment rate. Stocks fell a bit on the news and the dollar gained that day.  Stocks gained for a few days afterwards on the realization that the increase was due in part to greater labor force participation (people who had given up looking for jobs started to look again, a good sign). The rest of the month was basically flat.

Now, if we put the NFP together with what we believe to be the prevailing view of the economy, what we (as traders) want to see is some data that indicates the prevailing view is wrong. So what I would suggest is to come back to this article after the NFP is released; not for an immediate short-term reaction but to see if a reason exists for a trend to be established which will be where the best potential for a good trade will exist.

For example, if by some miracle the unemployment rate were to fall, there would be a good chance to see stocks get a boost over the next few weeks. That would put some pressure on the dollar vs. the euro, pound and A$, and it probably would be positive for those currencies against the yen as well.

A Great Trader

In any discussion of great traders, Marc Faber (the original Dr. Doom) surely comes to mind as being right at the top of the list. He correctly called the commodity rally and dollar bear market early in the decade and more recently said back in March that stocks had probably bottomed.

I always look for his interviews on Bloomberg and CNBC because they’re both entertaining and informative. And I just love the way he concluded his monthly bulletin back in June 2008:

“The federal government is sending each of us a $600 rebate. If we spend that money at Wal-Mart, the money goes to China. If we spend it on gasoline it goes to the Arabs. If we buy a computer/software it will go to India. If we purchase fruit and vegetables it will go to Mexico, Honduras and Guatemala. If we purchase a good car it will go to Germany. If we purchase useless crap it will go to Taiwan and none of it will help the American economy. The only way to keep that money here at home is to spend it on prostitutes and beer, since these are the only products still produced in US. I’ve been doing my part.”

Faber was on Bloomberg the other day saying that the dollar was likely to gain over the next 4 to 6 weeks. If we get a big jump in the unemployment rate he could turn out to be right, especially if riskier assets like stocks and commodities are sold (we did get a jump of 0.5 last month and we didn’t see a strong sell off). But if the data goes the other way (meaning the unemployment rate falls), he’ll likely wind up with egg on his face.