Goldmand Sachs is charged by SEC and the financial stocks were hit by the news. But Elliott Wave International has warned investors long time ago that Goldman Sachs may not survive this bear market.
Goldman Sachs Charged With Fraud: Who Could Have Guessed?
The firm's history suggests its vulnerability in periods of negative social mood. By Vadim Pokhlebkin
April 16, (Reuters) - Goldman Sachs Group Inc was charged with fraud on Friday by the U.S. Securities and Exchange Commission in the structuring and marketing of a debt product tied to subprime mortgages.
Shocked? Most of the subscribers to Elliott Wave International's monthly Elliott Wave Financial Forecast probably weren't. In the November 2009 issue, the EWFF co-editors Steven Hochberg and Peter Kendall published a careful study of Goldman Sachs' history -- and made a grim forecast for the firm's future.
In this special three-part series, we will release the entire Special Report to you.
Special Section: A Flickering Financial Star (Part I - April 19, 2010) At the Dow’s all-time peak in October 2007, Goldman Sachs Group Inc., was the undisputed heavyweight champion of the financial markets. And, thanks to its bailout by Warren Buffett and the U.S. Treasury as well as the liquidation of rivals Bear Stearns and Lehman Brothers, its reign lives on. Come December, earnings and bonuses will reputedly approach the record levels of 2007. If the market can hold up, it might happen. But as the stock market retreat grabs hold, Goldman Sachs will experience an epic fall.
To understand the basis for this forecast, we need to review the firm’s history in light of socionomics.
At the beginning of the last century, Goldman Sachs originally made a name for itself with its first initial public offerings, United Cigar and Sears Roebuck. The deals came as the stock market made a multi-year top in 1906. Within months, the panic of 1907 was on, and a U.S. Interstate Commerce Commission investigation of the Alton Railroad Company bond offering, in which Goldman participated, was in full swing. According to The Partnership, Charles Ellis’ history of Goldman Sachs, the deal was “long remembered as ‘that unfortunate Alton deal’.” The bond issue allowed a considerable cash surplus to be paid out to shareholders in the form of a one-time dividend, a standard financial maneuver in the preceding bull market. In fact, the deal was unknown to the public until it came before the ICC in 1907. “Then, probably to the surprise of the syndicate, the verdict was practically unanimous against them. They were tried before the bar of public opinion and found guilty,” said author William H. Lough in Corporation Finance. Lough added that syndicate members “ought not be too severely criticized for they merely acted in accordance with the custom of the period.”
So it goes when social mood, and concurrently the market’s trend, changes; customary Wall Street devices are invariably recast as the instruments of evil financiers.
Another bear market problem is that Wall Street firms are just as susceptible to negative mood forces that tear away at even the most close-knit social units. From 1914-1917, a major rift emerged between the founding Goldman and Sachs families, and the Goldman side of the partnership left the firm. The tension endured through several generations, and as late as 1967 it was said that “hardly any Goldmans are on speaking terms with any Sachses.”
Larger degree social-mood reversals create larger bear-market complications. The firm’s biggest and most devastating setback came after the Supercycle degree top of 1929.
Leading up to the market high, Goldman Sachs Trust Company took off, playing a role in the then-financial mania similar to the one that hedge funds perform today. With the help of successively higher levels of leverage, GSTC issued a quarter billion dollars worth of new shares the month before the September 1929 peak (many of which were held in its own account), leaving it completely exposed to the decline that followed. The firm survived only because a quick-witted former mailroom employee, Sidney Weinberg, took charge and used the stock market rally in early 1930 to jettison many of the firm’s equity positions. Weinberg also turned out to be an investment banking savant. While the firm made no money for the next 16 years, he served on the war production board and carefully cultivated key relationships in business and government. In the middle of Cycle wave III in 1956, Goldman completed the largest IPO in history, delivering Ford Motor Company into the public’s hands.
The firm was not yet a major force on Wall Street, but by hiring MBAs from top schools, fostering a reputation for fair dealing and maintaining a partnership structure that aligned the ownership of its principals with the long-term success of the firm, Weinberg laid the foundation for rapid growth. In the words of Gus Levy, Weinberg’s successor, Goldman Sachs was “long-term greedy.” Another Levy secret was to be certain that positions exposing capital were “half-sold” before they were entered into.
In the November 2009 issue of Elliott Wave International's monthly Elliott Wave Financial Forecast, co-editors Steven Hochberg and Peter Kendall published a careful study of Goldman Sachs company history -- and made a sobering forecast for the firm's future: "Goldman Sachs will experience an epic fall."
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Special Section: A Flickering Financial Star (Part II - April 21, 2010) Despite careful stewardship, Goldman's reputation faltered as stocks fell in 1969-1970. When the Penn Central Railroad went under, it was revealed that Goldman sold off most of its own Penn Central holdings before the June 1970 bankruptcy. This was another case of shifting standards, as Goldman's customers were all institutions dealing in unregistered commercial paper. They should have known the high odds of failure, as the railroad’s stock was down almost 90% when it finally failed.
As Cycle wave IV touched its low in October 1974 (S&P; see historic chart in Part I), a jury ruled, however, that Goldman “knew or should have known” that the railroad was in trouble. But Goldman Sachs company survived the negative judgment and grew quickly as the Cycle wave V bull market took off beginning in 1975.
As the chart shows, its rise to 2007 was meteoric. It was in this period that Goldman “reinvented itself” as a “risk-taking principal.” By 1994, Goldman Sachs: The Culture of Success (by Lisa Endlich) says compensation policies had tilted so heavily toward risk taking that one vice president noted, “everyone decided that they were going to become a proprietary trader.” In that year, the firm suffered its first capital loss in decades as stocks sputtered, but, within a year, the Great Asset Mania was in full force and Goldman's appetite for risk took off with that of the investment public.
In 1999, the last year of a 200-year Grand-Supercycle-degree bull market, Goldman Sachs, appropriately, went public, becoming the last major Wall Street partnership to do so. As Bob Prechter's Elliott Wave Theorist said at the time, “Some of the most conspicuous cashing in has come from the brokerage sector, which has a long history of reaching for the brass ring near peaks.”
The Partnership notes that by May 2006, when a wholesale financial flight to ever-riskier financial investments was in its very latter stages, Goldman had “the largest appetite and capacity for taking risks of all sorts, with the ability to commit substantial capital.” As other firms felt the sting of an emerging risk aversion, Goldman profited by shorting the subprime housing market and putting the squeeze on its rivals. The firm earned $11.6 billion in 2007, more than Morgan Stanley, Lehman Brothers, Bear Stearns and Citigroup combined. Merrill Lynch lost $7.8 billion that year.
Another bull market initiative explains Goldman's relative strength since 2007. It dates back to the hiring of a former U.S. Treasury Secretary, as the Dow peaked in Cycle III in 1968 (see chart in Part I). This was the firm’s first foray into the upper reaches of the U.S. government. In wave V, the flow of talent went the other way and tightened the bond, as executives regularly moved from Goldman to Washington. This process was aided in part by a Goldman policy that pays out all deferred compensation to any partner who accepts a senior position in the federal government.
In May 2006, Henry Paulson, Goldman's chairman, left to become Secretary of the U.S. Treasury. Over the course of wave V and its aftermath, when government was increasingly relied upon as the buyer of last resort, these associations proved valuable to Goldman. Eventually they will weigh heavily upon the firm, but the value persists for now because the government is playing its socionomic role and clinging tenaciously to the expired trend.
Another important late-cycle development is Goldman's all-out effort to court, rather than avoid, conflicts of interest. From the 1950s through the early 1980s, Goldman leaders assiduously avoided even the perception of a conflict of interest between the firm’s positions and those of its clients. Goldman's current leader, Lloyd Blankfein, “spends a significant part of his time managing real or perceived conflicts.” Says Blankfein, “If major clients -- governments, institutional investors, corporations, and wealthy families -- believe they can trust our judgment, we can invite them to partner with us and share in the success.”
The strategy paid off big in 2008 when Henry Paulson, who was still in charge at the Treasury, helped the taxpayer step in to rescue Goldman. According to a Vanity Fair article by Andrew Ross Sorkin, Paulson had signed an ethics letter agreeing to stay out of any matter related to Goldman. In September 2008, however, Paulson received a waiver that freed him “to help Goldman Sachs,” which was faltering under the financial meltdown of a Primary-degree bear market.
It may be that the best interests of Goldman are perfectly in line with those of the nation, but in the combative atmosphere of the next downtrend in social mood, we are quite sure that voters will not see it that way. Also, the potential for self-enrichment already appears to have overwhelmed a key player. The latest headlines reveal that another former Goldman Sachs chairman, Stephen Friedman, negotiated the “secret deal” that paid Goldman Sachs $14 billion for credit-default swaps from a bankrupt AIG. He did this as chairman of the New York Fed while also serving on the board of Goldman Sachs.
Special Section: A Flickering Financial Star (Part III - April 23, 2010)
With the market’s downtrend recently in abeyance, these transgressions failed to capture the imagination of the public or the scrutiny of law enforcement. But the extreme recriminatory power of the next leg down in social mood suggests that Goldman’s dealings will become a lighting rod for public discontent.
In January 2008, Elliott Wave Financial Forecast noted that Goldman’s success relative to the rest of Wall Street pointed “to the eventual appearance of a much larger public relations problem in the future. In the negative-mood times that accompany bear markets, conflict of interest charges will come pouring out.” The recent revelations about Paulson’s and Friedman’s actions are exactly that to which we were referring. Additional claims against Goldman -- including front-running its clients and profiting from inside information -- are already too numerous to mention. As the bear market intensifies, the firm will attract scrutiny as easily as it brushed it off in the mid-2000s.
Based strictly on the form of its advance, a July 2007 issue of The Short Term Update called for a peak in Goldman shares at $234. Goldman managed one more new high to $250 in October 2007; it then fell 81 percent to a low of $47 in November 2008. The stock market’s wave 2 rise brought Goldman back to $193 on October 14. Its affinity for marching in lock-step with the DJIA strongly suggests that Goldman will decline to below its November 2008 low.
Another key socionomic trait is for the most successful recipients of bull-market goodwill to be singled out for special treatment in the ensuing decline. Even fellow financiers are taking aim. In a not-so-veiled reference to Goldman, one Wall Street titan said that big profits made by investment banks are “hidden gifts” from the state, and resentment of such firms is “justified.” Let the bloodletting begin.
Let the Buyers (of Stock) Beware
Goldman’s heavy involvement in the hedge fund industry is another bull market asset that will become a huge liability in the next wave lower. In January, when some minor insider trading charges were brought forward, Elliott Wave Financial Forecast stated that they were only a first puff of “what promises to be a huge mushroom cloud.” The next much larger puff, and its ability to quickly envelop the financial markets, was put on display as the hedge fund Galleon Group went from insider trading charges to complete liquidation in a matter of days. The headlines are already pointing to a potential chain-reaction: “Galleon Wiretaps Rattle Funds as Insider Trading Targeted.” Reports indicate that the Galleon investigation actually began in November 2007, one month after the start of Cycle wave c.
Back in 2007 when Elliott Wave Financial Forecast talked about the “conspicuously tight knit” nature of hedge fund participants, we added that in bear market times, these “men will turn on each other out of a need to survive.” According to reports, that is exactly what happened. The central witness “who brought down the hedge fund” suffers from “financial woes” and “is working with law enforcement in hopes of receiving a lighter sentence.” The bear market is already squeezing the most aggressive bulls from every angle. New legislative and administrative initiatives are being proposed, and in some cases enacted, that will reduce executive pay at bailed-out financial institutions by up to 90% and attempt to shift the cost of bailouts from taxpayers to other large financial companies. The most far reaching “reforms” probably won’t take effect until later, when the decline is over or nearly so.
Finance led the way down in 2007; so we shouldn’t be surprised by its apparent willingness to do so again. ... This time however, the decline will be a third wave at Primary degree, which should be far more intense than the initial Primary-degree decline from October 2007 to March 2009. Stay tuned.
This article was syndicated by Elliott Wave International. EWI is the world's largest market forecasting firm. Its staff of full-time analysts provides 24-hour-a-day market analysis to institutional and private investors around the world.
Vadim Pokhlebkin joined Robert Prechter's Elliott Wave International in 1998. A Moscow, Russia, native, Vadim has a Bachelor's in Business from Bryan College, where he got his first introduction to the ideas of free market and investors' irrational collective behavior. Vadim's articles focus on the application of the Wave Principle in real-time market trading, as well as on dispersing investment myths through understanding of what really drives people's collective investment decisions.
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