MARKET WATCH
Trust Shattered, Wall Street Can't Afford Coincidences
By GRETCHEN MORGENSON
[W] all Street analysts are definitely under the microscope these days. Which makes a sequence of events of last Thursday and Friday involving Goldman Sachs' semiconductor stock analyst very intriguing.
Semiconductor stocks were crushed on Thursday when the Taiwan Semiconductor Manufacturing Company announced that it was sharply cutting its capital expenditures because of nonexistent demand for chips. Investors in chip stocks ran for the exits, correctly assuming that if such a big maker in Taiwan saw no demand, neither would the rest of the producers.
Shares of big-name United States producers like Intel and Applied Materials sank on the news. The Philadelphia Stock Exchange Semiconductor Index — known affectionately as the Sox — tumbled. And the action took down the Nasdaq as well.
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Although the Sox closed down 10 percent on Thursday, the index had been far lower earlier in the day; it recovered on significant buying. One especially large trade in the afternoon came from Goldman Sachs: the purchase of 10,000 call options on an exchanged-traded fund — called Semiconductor HOLDRs Trust — that is a basket of large semiconductor stocks.
The options are traded on the Chicago Board Options Exchange, and an order to buy 10,000 is unusually large. The open interest on these options — similar to the freely trading shares, or float, on a common stock — was around 1,400 before the order came in.
Any investor buying call options is betting that the stock underlying them is going to rise significantly. Given the excessive volatility in the market as a whole and the wide swings characteristic of semiconductor stocks in particular, it would take a person of great confidence to make such a trade.
Now for the intriguing part. On Friday morning, two hours before the market opened, James Covello, the semiconductor analyst at Goldman, upgraded the semiconductor equipment sector to overweight from market weight. Mr. Covello's reasoning? The big selloff in the sector was overdone.
"While fundamentals are not likely to improve in the near term, we believe that funds flow and seasonality may drive a meaningful move in the stock," he wrote. Mr. Covello added that his call on the group would be appropriate for shorter-term investors "who can be nimble enough to take advantage of a funds flow-driven rally and/or seasonality in the electronics supply chain." In other words, his recommendation was a trading buy.
When asked about these events, Katherine Baum, a spokeswoman at Goldman Sachs, said: "There is absolutely no connection between any of Goldman Sachs' trading activities and its investment research. And given the current environment it's outrageous to suggest that there is." She added that Goldman has strict guidelines on how much an analyst can communicate around an upgrade or downgrade. She declined to comment on whether the purchase was made by the firm for one of its customers or for the firm's own trading book.
Maybe it was just a giant coincidence that a Goldman Sachs trader put in an order to buy almost seven times the open interest in call options on the Semiconductor HOLDRs half a day before the firm advised its clients to buy into the sector. Although the shares in the exchange-traded fund closed on Friday roughly where they had wound up the previous day, they rose 3 percent early in the day as news of Goldman's upgrade spread. It is unclear whether the call options were sold.
In life, things happen by accident and they happen by design. It is not always possible to know which force is at work in each situation. But this much is known: Wall Street firms thrived during the late 1990's in part because investors were willing to suspend their disbelief. Those days are over. And Wall Street firms had better get used to the scrutiny.
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