Goldman to Benefit From Improving Trading Environment

Goldman Sachs (NYSE: GS) is largely recognized for its trading prowess; however its earnings came in lighter than expected in part due to a difficult trading environment. Goldman competes Morgan Stanley (NYSE:MS), JP Morgan (NYSE:JPM), Credit Suisse (NYSE:CS), and UBS (NYSE:UBS) in trading, investment banking and asset management services.

We have a $167 price estimate for Goldman Sachs, which is around 4% ahead of the current market price.

Trading Assets Increasing

The relative increase of Bonds, Currencies & Commodities (BCC) trading assets in 3Q FY10 from 2009 can potentially provide some insight on the outlook for these banks in terms of their sales & trading activities. The trading assets for these businesses increase has varied from as high as nearly 20% by UBS and 17% by Deutsche Bank to only 3% by Citigroup. Goldman Sachs and Morgan Stanley and Credit Suisse have been on the conservative side with their Bonds, Currencies & Commodities trading assets increase from 2009  being 8% and 12% and 11% respectively.

We consider the trading assets for banks as the fair value of their financial instruments, which they use for trading purposes. It reflects the proprietary capital they can leverage for generating returns. For most of the investment banks we cover we have separated their sales & trading division into BCC and equities trading, including the respective derivative assets in them. Then we calculated their relative contribution to each of the banks’ stock price. We have found that the the trading division is one of the largest drivers to value compared to M&A, equity underwriting and debt origination.

We estimate that Goldman Sachs’ (NYSE: GS) Bonds, Currencies & Commodities (BCC) division accounts for around 37% of our $167 price estimate, and Equities Trading 17%. Similarly for Morgan Stanley (NYSE: MS), the BCC division accounts for around 26% of our $21.54 price estimate, and Equities Trading 21%. And for Citigroup (NYSE: CS), we estimate that the Sales & Trading division as a whole accounts around 36% of our $4.17 price estimate.

Fixed Income, Currencies and Commodities

In sales & trading we believe that the bonds, currencies & commodities assets have more ability to influence earnings for a bank as they are often grouped together and cover a much wider range of asset classes that often trade in larger volumes than equities. Between 2006 and 2009, trading assets for Bonds, Currencies & Commodities Trading declined. This was largely a consequence of the subprime crisis and later the global economic downturn, which resulted in a fall in liquidity and volumes due to which when the banks marked-to-market their assets, a lot of them went deep out of money, becoming toxic assets on their balance sheets.

The way the trading assets for the above banks has trended between 2006 and 2009 can be identified as a major  indicator of the performance of their sales & trading divisions in particular, and the whole bank in general, as we discussed above, the contribution of sales & trading to the stock price of different banks.

Goldman Could Gain on Better Trading Environment

While all banks would benefit from an improving environment, Goldman could benefit disproportionately given that it has a heavy exposure to trading by our estimates. The yield on trading assets for BCC decreased from 5.8% in 2005 to 1.4% in 2008, with the bank incurring trading losses when returns across most major asset classes were sharply declining. However, with the global economic environment slightly improving in 2009, the yield shot up to close to 9%.

We expect the yield to gradually trend towards 5% by the end of the Trefis forecast period, with the improving economic environment increasing liquidity and improving returns across asset classes. If instead it trended close to 6%, for BCC this would add just under 10% to our price estimate.