Online Brokers Face Light-Volume Pinch

NEW YORK ( TheStreet) -- A sooner than usual decline in U.S. equity trading volumes is likely to impact fourth-quarter numbers for online brokers such as E*Trade Financial ( ETFC) and TD Ameritrade ( AMTD), as well as the performance of specialty firms and exchanges.

While the markets typically experience a slowdown in trading activity as the holiday season kicks off, this year the decline has begun earlier than usual as the weak economy continues and investors worry that the financial crisis isn't over yet.

Traders and investors also typically lock in year-end positions at some point, whether for tax reasons or simply to take vacation time during the holiday season, and may be doing that earlier this year, given the strong run-up in stocks from the March lows.

In contrast, this summer saw a surge in trading activity for high-volatility stocks such as Citigroup ( C), Bank of America ( BAC), General Electric ( GE) and AIG ( AIG). Including Wells Fargo ( WFC), the list makes up the five most active stocks on the New York Stock Exchange so far this year. Citigroup alone saw nearly 18.5 billion shares change hands year-to-date as of Oct. 31, according to data from the NYSE.

In August, typically the slowest month of the year, retail trading volumes of these five stocks represented roughly one-third of the total trading volume on the Big Board for the entire month as active investors jumped in and out of positions.That number has since fallen to about 16%, according to Sandler O'Neill's Rich Repetto.

The heavy trading in these names came amid the broader market rebound as the Dow Jones Industrial Average has risen roughly 60% from its low of 6,547.05 on March 9.

Normal seasonal trends have been thrown off by the activity this past summer -- so much so that "you could be seeing the beginning of a slowdown until the end of year, barring any major market event or news," Repetto says.

And while things can change quickly, for the most part, the average retail investor is sitting on the sidelines, Repetto says. "Upwards markets are normally good, but the buy-and-hold guy is still a little hesitant," he says. "There is still plenty of cash on the sidelines."

Raymond James analyst Patrick O'Shaughnessy said in a recent research note that he estimates DARTs, or daily average revenue trades, for the online brokers will be down between 8%-12% in November from October levels. For the fourth quarter, he believes the overall volume picture is "looking increasingly poor" and is now modeling for a sequential decline of 14% in U.S. equities trading for the three-month period, a performance that would represent average daily volume of 8 billion for the quarter. As a result, O'Shaughnessy, who covers the online brokers and exchanges, has reduced earnings estimates for most of the companies he follows.

Larry Tabb of Tabb Group, a financial markets research and advisory firm focused on the capital markets, says trading through the end of the end of the year will depend on the economy. "People are worried that the markets will retrench," Tabb says. "We're still seeing pretty soft economic numbers and questions as to whether the economy will sustain continued growth."

Investor confidence worldwide saw a solid decline in November vs. October, according to a recent reading of the State Street Investor Confidence Index, which measures confidence by assessing the changes in institutional investors' equity holdings of risky assets by region.

This month, the index fell 7.6 points to 100.8. State Street ( STT) says that a reading of 100 in the index represents a "neutral level, where institutions are neither allocating towards nor away from risky assets." North American investors specifically registered on the index at 102.2 this month, State Street says.

"Across all regions, institutional investors are largely treading water; neither increasing nor reducing their aggregate holdings of risky assets," Ken Froot, a Harvard University professor and the index's co-developer, said in a statement. "Overall, investors are displaying some caution about the current level of equity valuations, and a desire to see more evidence of real economic activity and aggregate demand, particularly in the U.S., before adding to equity exposures."

Another factor weighing on year-over-year comparisons of trading volume for the fourth quarter is that there is less "panic trading" this year, says Jason Ren, an analyst at Morningstar.

"The financial crisis has largely subsided. Last year's amazing trading volumes were largely to do with uncertainty in the market. But now with a lot of the systemic risk has subsidized so there is not as much panic trading," he says.

Still "it's not like trading revenue is going to fall off a cliff," Ren says.

The combination of lower volatility and the usual slowdown associated with the holiday season are taking a toll but Raymond James' O'Shaughnessy also believes mixed economic data of late points toward the Federal Reserve maintaining interest rates at current levels for a few more quarters, a development that he says could push back "the biggest earnings growth catalyst for the sector."

O'Shaughnessy expects that, among the online brokers, E*Trade will see the sharpest falloff in DARTs for the fourth quarter. The analyst now estimates the struggling firm to break even for the fourth quarter, down from a prior expectation for a small profit. He rates the company at market perform -- the equivalent of a hold rating.

Investment Technology Group ( ITG), a specialized agency brokerage and technology firm that partners with asset managers, will be one of the companies hit hardest by any slowdown because of its heavy reliance on U.S. trading volumes, according to O'Shaughnessy, who has a market perform rating on the stock.

As for TD Ameritrade, O'Shaughnessy expects the falloff in volumes to cut into its commissions, which comprise around 55% of the firm's total revenue, but he maintained a strong buy rating on the stock and lifted the price target by $1 to $24, saying he sees "further upside" because of the company's earnings potential if rates rise, lower interest expenses resulting from its $1.25 billion debt offering last week, the potential for a stock buyback or dividend payout in the next few months, and the favorable impact that broad strength in options trading should have on the acquired thinkorswim operations.

Charles Schwab ( SCHW) is expected to be least affected by the lower trading revenue since it only comprises approximately 20% of the firm's total revenue. Strong market performance resulting in higher asset management fees will "more than offset" any decrease in trading commissions at Schwab, O'Shaughnessy writes.

--Written by Laurie Kulikowski in New York.

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