Buy MS, Short GS

First, let's look at the short side of the trade and the "nonevent."

Is Goldman Sachs really that much better than its peers to justify its outstanding stock performance and premium valuation? If you have been reading me, you should already know the answer to that rhetorical question.

I do not believe Goldman's shares deserve to be on an island -- the company operates in the same markets as Citigroup and Merrill Lynch , and likely partook of the same sins. An eyebrow should rise on a glance of the chart below. Something's wrong here. Is Goldman that much better at managing risk?

As you can see, while GS shares were up nearly 20% through the 12 months ended Nov. 7, each of its peers is at least 20% underwater during that same span. Even after its recent backtracking, Goldman shares still offered a total return of 8.2% year to date through Nov. 7. There's a very good reason for this, as long as it's true. It's the nonevent mentioned previously.

Unlike peers Bear Stearns , Citigroup, Merrill Lynch and Morgan Stanley , Goldman has yet to announce a significant financial asset writedown and has reportedly denied rumors that it would. If GS really managed risk that well, then its stock probably deserves the reward its shareholders have enjoyed. However, I believe this premise is false, and GS investors stand a decent chance of seeing a charge at this firm as well.

When comparing the valuations of this group, we have to take one important thing into consideration. Some of the firms have seen more significant adjustment to their earnings and growth estimates than have others. Also, Morgan's data are not updated for the charge yet, as analysts are still likely updating their models.

With the fourth quarter nearing its end for these firms, things may even out as most of them potentially seek to get their at risk assets charged off in the current fiscal year. The fourth quarter is notorious for kitchen-sink write-offs, and the investment banks have good reason to write off as much as possible now, since they would want to reduce risk of write-offs in 2008. So in the table that follows, I took earnings estimate change into account.

The tables above show the main difference between Goldman and its peers, but can Goldman really being doing that well of a risk-management job, or is the news of Goldman's write-off pending? One thing seems certain: If the company has assets to burn, its stock is going to approach those of its peers. Thus, the upside potential for the shares seems not worth the near-term event risk. I would go so far as to bet on it, and suggest shorting GS alone or as part of the pair trade this article outlines.

The Long End of the Trade

Earlier this week, Morgan Stanley announced that it would also post a charge of $3.7 billion in its fourth quarter, but the shares were up yesterday, the day after the press release. What's more impressive about this is that all of the firms discussed in this article were lower yesterday. Why, you ask?

Morgan wisely declared that its total remaining risk is only $6.0 billion. This information brought clarity to a frighteningly uncertain outlook and gave investors reason for hope. The value of this declaration was especially powerful because of the activities of Morgan's peers.

Citigroup recently revised its initial charge significantly higher not long after first announcing what was a record breaking write-off. Merrill Lynch, after surpassing Citigroup's initial charge, is now under investigation by the SEC, but more important to MS investors, it declared its at-risk assets at $27 billion, significantly greater than Morgan's announced risk. In sum, Morgan's provision of clarity to a previously uncertain outlook has solidified expectations.

In our valuation table above, the impact of the pending charge is not yet reflected in Morgan's fiscal 2007 EPS estimate. But with the fiscal year nearing a close and ongoing operations the main concern of investors, it's '08 that really matters.

On the basis of the '08 estimate, which could be revised a little lower as analysts update their models, MS shares trade at significant discount to peers on a P/E-to-growth (PEG) basis. Its long-term growth outlook could be revised lower as well, bringing its valuation toward peers. Even so, I believe risk here is limited, and the stock looks cheap.

Analysts like to look at price-to-book and price-to-assets-under-administration for firms like these, but we expect the asset uncertainty is at play in devaluing these ratios. However, this also illustrates the reason why MS shares rose yesterday -- we know the risk, and it's relatively low.

In buying MS and shorting GS, you effectively reduce systemic risk while potentially benefiting from alpha return on both ideas. To the layman, if the market goes down or up, you should still generate a profit from this position while limiting risk. This holds as long as you close out both sides of the trade after the anticipated write-off is announced. If no asset impairment is declared, your risk should still be limited by the offsetting positions.