Fear Thaws Out for Investors as Online Brokers Defy Funk

With U.S. stocks stuck in the sleepiest funk since the dawn of the Internet, one group is waking up: online and discount brokers.

E*Trade Financial Corp., Charles Schwab Corp. and TD Ameritrade Holding Corp. rallied 5 percent on average in June on speculation rising shares and the lowest volatility since 1986 will entice individuals. While analysts say earnings will fall this year for firms including Goldman Sachs Group Inc. and JPMorgan Chase & Co., profits are poised to surge 20 percent or more at their discount brethren.

“They’re primarily focused on household investors, which are getting more confident as their fear thaws out,” Chad Morganlander, a money manager at St. Louis-based Stifel, Nicolaus & Co., which oversees about $160 billion, said in a June 25 phone interview. “It bodes well for broker-dealers. Volatility terrifies retail investors.”

The S&P 500 has rallied 4.7 percent since March to cap the longest stretch of quarterly gains in 16 years as central bank stimulus and confidence in economic growth sent stocks to all-time highs. The gauge decreased less than 0.1 percent to 1,960.23 at the close in New York today.

Maturing Bull

Prospects improve for firms catering to individuals as bull markets mature, according to James W. Gaul, a portfolio manager at Boston Advisors LLC, which oversees about $2.7 billion. The Standard & Poor’s 500 Index has risen about 25 percent annually since 2009, adding about $15 trillion to the value of U.S. shares.

Client trades at E*Trade, Schwab and Ameritrade have averaged 390,838 a day this year, up about 15 percent from 2013 even as overall share volume slipped in the U.S. At the peak of the dot-com bubble in 1999, daily trades averaged 108,835.

“Retail confidence tends to come later in an economic cycle than institutional confidence,” Gaul said in a June 27 phone interview. “Optimism is very high at the moment.”

E*Trade and Charles Schwab’s profits have historically risen in times of low volatility. When the Chicago Board Options Exchange Volatility Index hovered above 13 from 2004 to 2006, Schwab’s earnings increased at an annual average of 31 percent and E*Trade’s climbed 41 percent. The measure, known as the VIX, is below 12, compared with its two-decade average of about 20.

Need Turnover

“The smaller firms are not as driven by turnover as they are by asset level values,” Charles Peabody, an analyst at Portales Partners LLC, said in a June 25 phone interview. “That’s why they’re holding up better in terms of their earnings. Whereas the big guys need turnover of volume.”

The CBOE OEX Volatility Index, also known as the old VIX, rose 6.4 percent to 9.65 last week. On June 23, the gauge slipped 8.9, its first close below 9 since calculations started in 1986. It traded at an average level of 13.63 in 2013.

Individuals coming to stocks now are buying into a rally that is more than 5 years old, exceeding the average length of 4.1 years for bull markets since the end of World War II, according to data compiled by Bloomberg.

The S&P 500 trades at 17.9 times the reported earnings of its members, close to its highest valuation in four years. Stocks last saw a decline of more than 10 percent between April and June 2012 from intraday levels. This year, the closest it’s come was a 6.1 percent slide from the middle of January to February, data compiled by Bloomberg show.

Deeper Selloff

Given how long it’s been since a serious decline, signs of weakness now “could begin to gain the advantage with market participants and cause a deeper selloff,” Nicholas Colas, chief market strategist at ConvergEx Group, a trading services company in New York, wrote in a June 20 note to clients.

E*Trade’s adjusted earnings per share are projected to climb 55 percent in 2014. The same measure at Charles Schwab is forecast to increase 24 percent, according to analyst estimates compiled by Bloomberg. That compares to an expected year-over-year decrease of 18 percent for Bank of America Corp. and declines of 4 percent and 5 percent for Goldman Sachs and JPMorgan, the data show.

In the second quarter, E*Trade reported adjusted earnings per share that exceeded analyst estimates by 45 percent, while Charles Schwab beat expectations by 9.1 percent. JPMorgan fell 11 percent short of forecasts for the same period.

Since the start of 2014, analysts have cut their annual profit forecasts for Citigroup Inc. by 13 percent and Bank of America by 29 percent, estimates compiled by Bloomberg show. The earnings forecast for E*Trade has surged by 30 percent year-to-date, while Charles Schwab’s has climbed 6 percent.

Risk Off

“Stronger earnings and revenue growth have caused companies like E*Trade and Schwab to have more success” in the stock market, Matt McCormick, who helps oversee $11 billion as a fund manager at Cincinnati-based Bahl & Gaynor Inc., said in a June 24 phone interview. “With money-center banks, people are seeing no earnings growth and taking a little risk off.”

Bahl & Gaynor doesn’t own shares in any of the large money-center banks and doesn’t plan on buying any, McCormick said.

JPMorgan, the world’s biggest investment bank by revenue, said in a May regulatory filing that quarterly fixed-income and equities trading revenue will drop about 20 percent from a year earlier. Chief Executive Officer Jamie Dimon, 58, was the first head of a major U.S. bank to warn investors this year that trading was down, saying in February that revenue had fallen 15 percent.

Capital Markets

“The capital markets areas of all these banks will be challenged this quarter,” Walter Todd, who oversees about $980 million as chief investment officer at Greenwood Capital Associates LLC, said in a June 24 phone interview. “The banks aren’t seeing as many fees from trading, and they don’t have as much of an opportunity to trade on their own behalf.”

Even amid the risk of a correction and the expected decline in profits at bigger financial firms, bank stocks will be a “go-to” group for investment once the Federal Reserve raises interest rates, according to Dan Veru of Palisade Capital Management LLC.

While the Fed’s near-zero interest rates have lowered borrowing costs, they’ve also reduced the profitability of lending. When rates rise, lenders try to increase the amount they charge for loans faster than what they pay on deposits, leading to an improvement in profit margins.

Fed Bank of St. Louis President James Bullard predicted on June 26 that the central bank will raise interest rates starting in the first quarter of 2015. Fed Chair Janet Yellen has previously said that the central bank would consider a rate increase six months after the conclusion of its monthly bond-buying program.

“Brokerage firms and anyone with exposure to money market-type instruments or client money could benefit from higher rates,” John Carey, a Boston-based fund manager at Pioneer Investment Management Inc., which oversees $220 billion worldwide, said in a June 24 phone interview. “The benefit to big banks will be more muted, whereas with the brokers, you can see a pretty clear relationship between higher rates and better earnings possibilities.”

Before it's here, it's on the Bloomberg Terminal.