As Trading Volumes Plummet, What About Exchange & Investment Banking Stocks?
We’re coming off a year when the S&P 500 climbed 13.4% excluding the impact of dividends and heading first into the belly of the beast that is corporate earnings for the recently completed 4Q 2012. Yet despite those favorable figures for the S&P 500 as well as those for the Dow Jones Industrial Average and the Nasdaq Composite Index, trading volumes fell significantly in 2012. That drop is not new and has had dire consequences for a number of firms over the last few years. As move into 2013, it looks like that trend is set to continue.
Examining the monthly trading data published by the NYSE Euronext (NYX) shows that the company’s U.S. cash product trading volumes fell 26.8% in 2012 compared to 2011. This significant volume drop was also had at the Nasdaq OMX Group (NDAQ), which saw its U.S. equity volumes fall each quarter on a year over year basis and in most cases sequentially in 2012. I’d be remiss if I didn’t point out that the bulk of the year over year trading volume declines came in 3Q 2012 and 4Q 2012, which were down 39% and 28%, respectively.
In aggregate, 2012 U.S. matched equity volumes at Nasdaq OMX Group fell 20.4% compared to 2011 and in my view that should squash any argument that falling volumes at the NYSE were due only to market share losses. As my conversation with Keith Bliss, Senior Vice President of agency only brokerage firm Cuttone & Company, touched on, it’s not only trading volumes that are under pressure but also commissions as well. That’s a one-two punch to trading revenues. Data from Greenwhich Associates puts U.S. equity commissions at .3 billion in 2012 down just over 25% from the recent high of .9 billion in 2008.
Trading volumes and commissions were not the only Wall Street activities under pressure in 2012. Despite the flurry of year end merger and acquisition activity in the face of fiscal cliff related tax hikes, the number of deals in the US dropped 10% in 2012 to 6,357 deals from 7,077 in 2011, making it the slowest year for M&A since 2002 according to Ernst & Young LLP’s Transaction Advisory Services. While the final data on M&A activity in 4Q 2012 has yet to be fully tallied, the leaders in domestic M&A deal volume through the first nine months of 2012 were Goldman Sachs (GS), JPMorgan (JPM), Barclays (BCS), Morgan Stanley (MS) and Bank of America Merrill Lynch (BAC).
As I mentioned above investors are about to get hit between the eyes and potentially the wallet and trading account over the next week as nearly 500 companies report their quarterly results. The combination of those year over year declines in trading volume and M&A activity do not not bode well for domestic investment banks that derive a high degree of revenue and profits from the U.S. markets.
Now let’s be clear – there are a few types of banks – savings banks, hybrid banks that cut across investment banking activities and savings, and essentially pure play investment banks. Examples of those hybrid institutions include JPMorgan Chase (JMP), BB&T Corp. (BBT), Sun Trust (STI) and others. The impact of falling investment banking activity will vary depending on the actual exposure to revenues as well as profits that each of those institutions has on its respective income statement. Other firms like Goldman Sachs (GS) and Jefferies Group (JEF) derive a meaningful percentage of revenue and profits from principal transactions and investment management activities.
We’ve already seen a number of smaller investment banks close down or get taken over in recent years due to the trading downturn. Examples include Ticonderoga Securities, which prior to shutting its doors merged with Soleil Securities. WJB Capital Group, an agency broker which distributed third party research, shut its brokerage operations in early 2012. San Francisco based ThinkEquity shut down this past October and in late 2012 B. Riley & Co., LLC acquired San Diego based investment bank Caris & Company.
Looking ahead, the investment banks that are likely to feel the pain more than others are those small to mid-size domestic investment banks, such as FBR & Co. (FBRC), Evercore Partners (EVR), Greenhill & Co. (GHL) and JMP Group (JMP). In my view, investors should avoid those companies especially those like GHL and EVR that are currently trading well north of book value. Greenhill shares in particular are trading at 5.8x book value, while those for Evercore are trading at 2.4x.
Investors looking to this space should consider those investment firms that have a diverisified revenue stream as well as defensible positons. In other words, companies like Goldman Sachs (GS) and JPMorgan Chase (JPM) that have both scope and scale on their side.