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Goldman Sachs Can Fall Off the Fiscal Cliff

As lawmakers wrangled over budget cuts, tax increases and fiscal ideology in the third quarter of last year, businesses pulled back from merger activity and the financing of risk taking through stock and bond issuance. The ensuing slowdown in underwriting, in addition to a sharp drop off in merger activity hit the earnings of pure play investment banks like Goldman and Morgan Stanley, in addition to the earnings of units tucked within larger conglomerates JPMorgan and Bank of America (NYSE:BAC).

When the dust settled, Goldman posted its first quarterly loss in over a decade and Wall Street as a whole had its worst quarter since the depths of the financial crisis. Were the US to go over the fiscal cliff -- a scenario Goldman Sachs' top stock strategist doesn't take lightly -- who's not to say earnings couldn't return to such a dire state, in spite of general optimism headed into the bank's release on Tuesday morning?

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Analysts expect Goldman will earn $7.3 billion in revenue and $2.12 in earnings per share, according to ThomsonReuters data, a turn from a $0.84 that the bank posted in the third quarter of 2011. Earnings expectations are also buoyed by the generally strong reports from competitors Citigroup (NYSE:C), JPMorgan and Wells Fargo (NYSE:WFC) in October.

Goldman Sachs may operate cautiously as the fiscal cliff hangs over fourth quarter earnings, notes Michael Wong, an equity analyst with Morningstar.

"With the potential for a 'fiscal cliff,' Goldman Sachs and other banks will stay to the high ground in terms of liquidity and their capital structure," says Wong, in an interview earlier in October. Caution may not be great news for investors given that new regulations and declining leverage at Goldman are depressing some of the firm's key stock drivers.

Meanwhile, although a rising tide of analyst forecasts bodes well for Goldman's earnings, bank stock investors generally haven't been good at identifying risks to earnings a quarter or two out. After Goldman's shares touched levels above $120 for a sustained period following the bank's strong fourth quarter 2011 results in January, investors bid up shares only to see them fall sharply amid fears of the impact of ratings downgrades by Moody's.

On Monday, Goldman's chief equity strategist David Kostin put out a decidedly bearish stance on stocks headed into year-end, as the cliff wrecks what's been a strong year for equities. Kostin sees the S&P 500 (INDEXSP:.INX) falling over 10% through year-end, as Congress walks slowly toward the fiscal cliff, derailing C-Suite and consumer confidence.

"We assign a low probability that Congress addresses the 'fiscal cliff' in a benign fashion prior to year-end 2012," Kostin wrote, in a note that gave one-in-three odds the US will go over the cliff in January. Such a scenario would have a notably similar impact to the drain a budget ceiling standoff caused last summer.

All spring and early summer market participants assumed Congress would raise the borrowing limit before the ceiling was reached," writes Kostin, who notes a 17% plunge in the S&P as talks came down to the final hour. "[The] dynamics are actually similar because both debates involve date-specific deadlines that encourage brinksmanship," adds Kostin of the similarities between the 'fiscal cliff' and the 'debt ceiling.'

A forward-looking stance on the risks to bank stock earnings may put investors in good stead as the US hurtles toward a fiscal cliff in the wake of Presidential elections in November. That may especially be the case if Goldman Sachs reports blowout earnings on Tuesday, as some expect.

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