Goldman’s Grim Quarter

It’s easy to think that because Wall Street firms are on the inside, they must be much better at investing and stock-picking than everyone else. But actually there’s almost no evidence to suggest they are. In fact, Morgan Stanley and Goldman Sachs seem to find beating the market as tough as everyone else does.

That point was driven home yesterday when Goldman released its results for the third quarter, and announced that its profits had fallen 81 percent, to a relatively measly $107 million, solely because of trading losses. Goldman has always derived a much higher percentage of its revenues from proprietary trading–where the firm actively seeks to take profitable positions, as opposed to merely facilitating trades for clients–than its peers. In the past, especially the recent past, that’s meant that Goldman has been raking in profits hand over fist. But it’s also meant that the firm has been more vulnerable to market turmoil, and to misconceived trading strategies, than its peers.

In the first six months of this year, for instance, Goldman saw its revenues from “trading and principal investments” rise to $2.58 billion, up 55 percent from the first six months of 1997. But when the markets went south in late August, Goldman got crunched, along with Long-Term Capital and hedge funds across the world. And since Goldman’s asset-management business remains relatively small, the firm did not have the same earnings cushion that companies like Merrill Lynch and Morgan Stanley had.

As more than one piece pointed out back in June, when Goldman announced that it was planning to go public (a plan that was revoked in October), the firm’s reliance on trading makes its annual returns more volatile than many investors would like. Not coincidentally, the company’s co-CEOs, Jon Corzine and Henry Paulson, have been trying to expand Goldman’s investment banking and asset-management divisions, with some success. But Goldman’s culture has always been a more freewheeling trading culture, and altering that is not the easiest of processes.

Still, what’s most striking about Goldman’s results is not that they push an IPO further into the future, but that they make clear the absence of a secret formula for investing profitably. More than that, Goldman’s lack of success shows how difficult it can be to make money when global markets are becoming ever-more competitive.

Like Long-Term Capital, like D.E. Shaw, Goldman was doing a lot of what’s called “convergence trading” (or “pairs trading” or “relative-value trading”), wagering that price relationships between different assets (like two stocks or the bonds of two different government bonds) would return to their historical means. Even if that strategy was a smart one, it’s hard to see how successful it can be when everyone and their cousin are following it. At the same time, having everyone following the same strategy makes the pain all the greater when it blows up, because everyone’s trying to get out of positions at the same time.

Something similar happened to Goldman in 1994, when a series of interest-rate hikes by the Fed devastated the bond market. The firm’s trading revenues dropped precipitously. The years since have been good ones, but then they’ve been good ones for almost every investor. In a bull market, everyone is a genius. But when it comes to the market as a whole, no one is.