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U.S. stock drop could have been twice as bad: Goldman

The 6.4 percent drop in the Standard & Poor's 500 stock index last week was only about half as bad as it could have been, according to Goldman Sachs credit analysts.

A Goldman report on Monday said that stock investors appear "complacent" and taken by surprise in recent weeks by sovereign debt risk. Goldman Sachs is the most profitable Wall Street firm and is facing a fraud lawsuit from the U.S. Securities and Exchange Commission.

Goldman would have expected a 10 percent S&P 500 stock decline last week, judged by credit and options markets. Financial stocks also could have fallen as much as 12 percent last week, according to credit and options market metrics.

While the benchmark S&P 500 index fell 6.4 percent, the S&P financials sector index fell 6.6 percent.

Moreover, a rally in stock markets on Monday sparked by a $1 trillion European aid package may only be temporary, Goldman's report said.

Stock market investors should hedge in sectors where credit markets showed the most risk, said the report.

Goldman recommends buying put spreads in financials such as Capital One, American Express, Citigroup, Prudential and Hartford Financial Services Group, and for industrial companies, such as Dover, CSX Corp, Honeywell and FedEx Corp.

An investor typically uses a put spread as a lower cost method to express a bearish view rather than buying an outright put option, which gives the right to sell the underlying stock or asset at the strike price by a certain date.

"Credit investors had an unwavering focus on the potential fallout from a European debt crisis, while many equity investors seemed determined to look past these risks," said John Marshall, lead author of the report. "The European debt issue was in focus last week. Credit analysts were focused on this beforehand and last week."

The main index of investment-grade credit default swaps narrowed about 10 basis points on Monday to 100 basis points after global policymakers devised the emergency rescue plan to prevent Greece's debt crisis from expanding through Europe.

Recent credit market moves reflect a more bearish view than stock markets, Goldman said. Credit default swap spreads have widened about 25 percent in recent weeks, and implied volatility rose 60 percent since a pullback began on April 22, Goldman said.

Still, by some measures in credit markets, even credit yield spreads haven't made a clear judgment on the impact of sovereign credit risks emanating from Europe.

A widely followed credit default swap index saw spreads narrow about 9 basis points on Friday, while corporate bond spreads widened 8 basis points, according to benchmark indexes.

"When things get ugly, corporate debt is going to underperform," said one Morgan Stanley analyst.

One reason for the disparity was money managers who held corporate bonds could not sell them amid extremely volatile trading last week, traders said. So as a hedge, some investors bought credit protection to hedge against corporate bond declines.

"Our analysis makes no judgment as to which market is correct," referring to stock markets versus credit, according to the Goldman Sachs credit report.

"However, we see several reasons to believe the credit market potentially has an advantage in analyzing risks from the European debt situation that is driving the market," the report said.

"Greece and possibly other countries will need to implement fiscal tightening and structural reforms without derailing economic growth -- a tricky balancing act," the report said.