Tough Summer for Brokerages

"Broker stocks are sensitive to interest rate trends and expectations about volumes in the market. Everything is softer," says Philip Roth, chief technical market analyst at Miller Tabak. "This is the biggest correction since the bottom of 2002, and it has a number of months to run."

Roth says that there may be "several mediocre recoveries" amid a broader decline in the coming months, which probably means the broker stocks will sell off as well. In fact, many portfolio managers are starting to readjust their portfolios and dump high-beta stocks, those that move closely with the equity market, and invest in defensive areas.

Even some people who are bullish on the brokers concede that sentiment has shifted.

"They'd rather hold Kellogg's(K Quote) corn flakes than Lehman or Goldman," says Bernstein's Hintz. "Brokers were going down, frankly because [investors] said they wanted to be defensive."

Other signs of a slowing equity market hit the headlines last week. When the equity market is going to fall, retail-investor trading slows. E*Trade Financial said last Wednesday that its customers made fewer trades in May, the month the markets began to tumble. It says daily average revenue trades fell by 3% in May from the April tally. E*Trade also said customer assets fell 5% in May to $184 billion.

The brightest spot in the brokerage space last week was Bear Stearns(BSC Quote), whose upbeat outlook helped stanch the sector's bleeding on Thursday and contributed to the broader market's furious rally. On Friday, Sandler O'Neill analyst Jeff Harte upgraded the stock to a buy from hold and raised the price target by $6 to $151 per share.

"We remain bullish in our outlook for the capital markets environment heading into 2007 and note that the credit market continues to suggest that the economic- and business-sector environments are much stronger than reflected by the equity markets in recent weeks," the report said.

All that might be true, and certainly, when evaluating the brokers alone, the companies are positioned well. The large institutions continue to diversify their businesses by expanding overseas operations. Theoretically, this will give brokers strong earnings in the face of a U.S. equity decline.

"Domestic mergers only account for one-third of global M&A, and equity underwriting only about 35%," according to Hintz. "Certainly, [the brokers] are diverse."

Still, it probably won't matter. The temperamental equity markets were volatile last week, despite a mostly positive message from economic indicators and broker earnings alike. That sensitivity is ultimately bad news for brokerage shares.