Why 2010 Could Be a Tough Year for Wall Street

Most investors dislike volatility. When the market drops, stomachs churn. When the market rises, stomachs again churn if you missed the pop (as did many individual investors). If you bought on the way up, the ride is exhilarating--until it stops. And the damndest thing about markets is that they invariably stop rising at some point, and then fall.

On the other hand, Wall Street loves volatility. When stocks and bonds swing up and down, investors buy and sell them. That means commission income, and markups and markdowns, for brokers.

Volatility also provides trading opportunities, and the more volatility there is, the bigger the opportunity. The great housing collapse of 2007 gave hedge fund manager John Paulson the chance to make $15 billion for his investors, and over $3 billion personally. The next year, 2008, he reportedly made another $5 billion for his investors betting against big banks. His trading ability was crucial to spotting these opportunities. But the outsized volatility in housing prices and bank stocks enabled him to make gargantuan profits.

The big Wall Street banks often try to profit from volatility through proprietary trading--i.e., trading as principals. Goldman Sachs is famously skilled at this, and it's no accident that Lloyd Blankfein, Goldman's current CEO, came up through the ranks of the proprietary traders. Goldman has done well as a principal trading the ups and downs of the last three years.

Few prognosticators predict 2010 to be volatile. Most expectations for the economy range between modest growth to a double dip recession late in the year. Not many money managers are making glowing promises to their clients about the stock market, and the bond market seems murky more than anything else. Real estate may trend up slightly, or it may drop some more. No one really knows. Taken as a whole, the weight of current prognostications seems to indicate a muddled picture, with some asset classes moving up a bit and others down a bit. Assuming this to be true, Wall Street won't have the trading opportunities to hit the home runs of recent years. Hedge funds may struggle to stay ahead of the S&P 500. The big banks may have more modest returns than they did in 2009.

A year of pedestrian operating profits could prove tough for the big banks. They continue to hold many billions of hinky assets from the real estate crash, the credit crunch and the recession--CDOs, commercial real estate loans, defaulting credit card debt and so on. With the economic recovery slow, the banks will likely have to take more writedowns on these old lending mistakes. And there's always the risk of a new crisis in 2010. A major sovereign debt default (say, Greece or California) could dampen investor appetite for risk and highlight the virtues of holding cash.

Some believe commodities will be the big play in 2010. John Paulson and other money managers reportedly are betting on gold. But if the world's economies are truly recovering, they will pull up the fiat currencies against which the gold bulls are betting. And nobody expects a big jump in oil prices. One wonders if the recent reports of a brief cutoff by Russia of Belarus' supply might not have been someone in the Kremlin figuring on giving prices a little fillip.

If 2010 is a year without volatility, investors will breath easier. But Wall Street will probably make less money. With the ghosts of a lot of bad loans still haunting the Street, that could make it a tough year for the banks.