Global investment bank Goldman Sachs Group Inc. (GS, Financial) has taken on considerable trading risk in derivative contracts in the decade following the housing collapse. That might not end well regardless of how excellent the company has performed in the past or how many computers it gets to replace human traders.
The stock looks cheap at 8.5 times forward earnings, but the company remains too big to fail, and now it's too big to outperform the S&P 500 with too much downside risk attached.
Currently, Goldman Sachs is carrying over $56 trillion of total derivatives, backed by less than $1 trillion in total assets. This, however, may not be cause for alarm. After all, Warren Buffett (Trades, Portfolio)'s Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) owns more than 13 million shares of the financial powerhouse, good for a 3.5% stake. Moreover, Buffett added over 2.2 million shares to his holding last quarter.
Source: OCC / US Treasury
In 2008, Goldman reorganized itself as a financial holding company regulated by the Federal Reserve System. The majority of Goldman's derivatives are swaps. In 2008, legislation passed to require most swaps to trade through swap execution facilities as opposed to over the counter. This market is structured to prevent a ripple effect impacting the larger economy in case of a counter party default. That risk has risen along with interest rates.
Granted, Goldman Sachs is a global company with 40% of its net revenue generated outside of North America. It also has a history of being one of the best trading firms on Wall Street. Currently, it is in the midst of a $5 billion artificial intelligence transformation initiative to move the business further away from human capital.
Yet, remember the flash crash in 2010? The market dropped roughly 10% in less than 20 minutes due to algorithms. If Goldman (or any company) has a glitch in their matrix, then any number of these flash crashes could happen. At the same time, maybe we're getting smarter with our machine learning programming and this is more fear than real danger.
Looking strictly at the financials, Goldman has continued to book strong results. The company reported net income of $2.45 billion ($6.28 per share) on $8.6 billion in revenue during its third quarter. Estimates are for the company to earn $25 a share in 2019, which does make the current price seem like a bargain, but that number would be over 100% higher than it generated in the last 12 months. In other words, since the market is at the top of the capital cycle, investors are more likely to see a drop in earnings than a rise. Plus, my gut is telling me these derivatives are going to be more of a problem than investors realize.
This is an industry with a history of high-flyers that fell off by taking on too much leverage. As economic recovery in the U.S. begins to reverse, there's no way Goldman's stock remains propped up.
Disclosure: I am not long or short GS.
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