Inside Wall Street: Time for Investors to Lower Their Goldman Expectations?

Here's a glaring headline from July 21: "Goldman Profit Magic Goes Missing." Well, maybe we should start getting used to the idea that Goldman Sachs (GS) will no longer be the invincible Wall Street powerhouse it has been all these many years. That would mean investors need to lower their expectations as Goldman may now join rivals JPMorgan Chase (JPM) and Bank of America Merrill Lynch (BAC) as an equal.

That Wall Street Journal headline was inspired by the 82% plunge in Goldman's second-quarter earnings, which were hurt not so much by the $550 million it had agreed to pay the Securities and Exchange Commission to settle the securities-fraud lawsuit filed against it, but more by the huge losses from bad trading bets. Those surprises included wrong decisions on the stock market's direction, exacerbated by incredibly close-to-stupid moves by Goldman in its equity and proprietary capital trading, which is one of the mighty bank's top businesses -- traditionally a generator of enormous profits.

"It is an unusually large blunder," says the Journal, "given Goldman's reputation for prudent risk management."

Explaining the results, Chairman and CEO Lloyd Blankfein simply stated that the market environment "became more difficult in the second quarter and, as a result, client activity" across Goldman's businesses declined. Ah, if only it was that simple.

"Lost Their Mojo and Swagger"

What presumably happened was that Goldman's traders were so distracted by the SEC inquiry and so harassed that they went the extra mile to be overly careful to make sure they don't attract any more attention and not add damage to the fire by possibly committing more so-called "mistakes." As a result, they erred on the side of prudence and took on less leverage and risk, which isn't exactly in Goldman's nature.

"For a while there they lost their mojo and swagger," says the president of a California hedge fund that's a Goldman client. Indeed, Goldman's traders might stay very defensive for a while as they try to regain their footing.

Whether or not Goldman came out a winner in its $550 million SEC settlement, it's clear is that the No. 1 investment bank will continue to face other problems as daunting as its crossing swords with the SEC. It has many more lawsuits and litigations to face. In settling the SEC suit that focused the Abacus collateralized debt obligation contract, Goldman admitted it "made a mistake" in not disclosing the role of the usually bearish hedge fund, Paulson & Co., in structuring the deal, as well as Paulson's short position. (Late on July 22, news emerged that the SEC's inspector general has been asked to look into the timing of the Goldman settlement, so even that cloud may not be fully dissapated.)

Wall Street Keeps the Faith

How will Goldman get its golden reputation back and regain the trust and confidence of its elite customers and currently confused investors? Being constantly in the spotlight and under close scrutiny by the reenergized regulators means it'll have to walk a straight and narrow path, hampering Goldman's usual bravado and creative risk-taking. Perhaps we'll see more slumps like the disastrous second quarter as a result. After all, Goldman will definitely have limited elbow room in pursuing the highly lucrative "tails-I-win-heads-you-lose" kind of deals it pulled off during its halcyon days.

Still, support on Wall Street for the most profitable investment bank has hardly diminished. Indeed, the Street never did lose faith. All 28 analysts who follow Goldman quickly rushed to reiterate their almost boundless support. The handful of analysts who had revised their ratings to hold from a buy at the height of Goldman's crisis quickly restored their buy recommendations after the SEC settlement.

Guy Moszkowski of Bank of America attests that Goldman has a history of rebounding sharply from weakness inflicted by short-term market issues. And notwithstanding the eventual impact of the new financial reform law that President Obama signed on July 21, "Goldman will remain one of the most profitable firms in financial services," contends Moszkowski.

But as bullish as he is, the analyst concedes that Goldman's return on equity will drop to 14% to 15%, from an average of more than 20% in the past 11 years since it went public. Last year, Goldman's ROE was 24%.

Far From Its Previous Peak

The sole analyst who dared to hoist a sell alert on Goldman in early May was Standard & Poor's Matthew Albrecht. But when Goldman made peace with the SEC in mid-July, Albrecht modulated his stance and upgraded by his rating to a hold. He explains that the Goldman-SEC truce helped to resolve a serious challenge.

He cautions, however, that regulatory uncertainties remain. Goldman vowed to "reform its business practices." But will it? Some investors aren't so sure, considering that the same top management who led the company to its gigantic woes with the SEC are still running the show.

Albrecht notes that revenues were hurt by lower trading activity and could be further affected by new rules that'll emerge from the new financial regulations law. Although he upgraded the stock, Albrecht cut his 2010 earnings estimate by 49 cents, to $14.55 a share, and his 2011 forecast by 16 cents, to $17.64. Albrecht's price target for the stock is $162. The stock closed on July 22 at $146.55, off from its high last year of $194 and way down from its all-time peak of $250 reached in 2007.

Sticking With the Top Brass

Clearly, Goldman isn't out of the woods, and Albrecht acknowledges that it still faces an uphill battle to repair its damaged reputation. He warns that the SEC settlement could be just the first step toward renewing confidence in the company.

Like BP (BP), whose disastrous oil spill in the Gulf of Mexico shifted the headlines from Goldman's woes, the firm has ignored suggestions that it clean up its upper management to help alleviate public and investor discontent. The boards of both companies remain silent on the issue. Meanwhile, the stocks of BP and Goldman remain way off their highs. Don't bet on Goldman snapping back to those heights anytime soon.