An old Wall Street saying holds that "the market hates uncertainty."
Given the regulatory clouds hanging over the operators of financial exchanges—publicly traded outfits such as NYSE Euronext (NYX) and the CME Group (CME)—investors have come to loathe the very companies that enable the Street's day-to-day operations.
Shares of CME, the world's largest futures market, are off 19.4% since the beginning of 2010. NYSE, the owner of the largest U.S. stock exchange, has seen its stock drop 8.2%. IntercontinentalExchange (ICE), the commodities powerhouse, has lost 15% this year, while Nasdaq OMX (NDAQ), the owner of the second-largest U.S. equity exchange, is down 5.7%.
Losses deepened on Feb. 4 after a disappointing quarterly report from CME. The company's revenue fell 3.5% from a year ago, and earnings-per-share fell 6¢, or 1.7%, below analysts' estimates.
All the gloom could eventually create opportunities for patient investors, says Alan Lancz, president of Alan B. Lancz & Associates, which owns Nasdaq, CME, and NYSE shares.
For now, however, Lancz says, "I don't see a catalyst." Shares are beginning to look attractively valued, he adds, but 2010 could be tough on exchanges.
The financial crisis and fierce competition had already slashed exchanges' share prices over the past two years. In recent weeks, Washington's renewed focus on financial reform has slammed the stocks again.
"The big issue right now is uncertainty," says Larry Tabb, chief executive of the TABB Group, a research firm specializing in capital markets. Lawmakers and regulators are reviewing nearly every aspect of the way financial products are exchanged. "There are so many rules proposed by so many bodies that it's very difficult to keep track," Tabb says.
Analyst Patrick O'Shaughnessy of Raymond James (RJF) counts 12 major issues facing the industry, including proposals for a transaction tax and a ban on proprietary trading by bank holding companies.
How Exchanges Could Benefit
Executives at the CME argued Feb. 4 that new regulations could actually help exchanges. "There are few areas of potential harm to our business, and many areas that are potentially favorable for CME Group and other exchanges," CME Chief Executive Craig S. Donohue told analysts.
Among the biggest potential benefits to the industry is a drive to push more transactions onto exchanges, where complex financial products—of the sort that prompted a federal bailout of American International Group (AIG)—can be standardized and risk more easily monitored.
Yet investors say it's not possible to ignore regulatory risk when so much is happening in Washington. Keeping track of it all "would be a full time job in itself," Lancz says.
Investors have expected new financial regulations for more than a year. But the Massachusetts election of Republican Scott Brown to the U.S. Senate on Jan. 19, and subsequent tough talk about Wall Street from President Barack Obama, have raised the temperature in Washington.
Paul Zubulake, senior analyst at research firm Aite Group, thought Congress might be finishing deliberations on financial regulation by this point. Now, "this is looking like it may be an election issue for 2010," he says. So much uncertainty makes it difficult for exchange operators to plan or investors to make bets. "It overhangs the whole market," Zubulake says.
"It's hard to see how all that works itself out—if anything happens whatsoever," says Ted Harper, a co-portfolio manager of the Frost Dividend Value Fund (FADVX) and owner of NYSE shares.
Exchange stocks have been falling out of favor for years, as reflected in much cheaper valuations. The price-to-earnings ratio for NYSE Euronext dropped from 35.2x at the beginning of 2008 to 11.9x as of Feb. 4, a valuation lower than those of 81% of the companies in the S&P 500-stock index. The p-e ratio for the CME Group has plummeted from 45x two years ago to 20.1x today, but the company's valuation still remains higher than those of 71% of S&P 500 companies.
A Fee on Every Trade?
For exchanges, the biggest regulatory threat is probably a transaction tax proposed by some congressional Democrats in December. By placing a small fee on each trade, the tax would cripple the rapid, computerized trading that has boosted trading volumes in the past decade. In a Feb. 3 note, Raymond James' O'Shaughnessy rates the tax as "unlikely to be implemented."
Other rules and regulations could reduce volume by forcing traders to limit the size of their positions, banning particular kinds of trades, or making traders meet stricter risk controls before accessing markets.
Other policy developments might not hurt the exchanges—but it's difficult to tell because details remain fuzzy.
The Securities & Exchange Commission, for example, said on Jan. 13 it was seeking comments on issues such as high-frequency trading (which helps exchanges by adding to their volumes) and "dark pools" (alternate trading platforms that draw traffic away from established exchanges). But the SEC hasn't proposed specific policies yet.
Trading for Banks' Own Accounts
On Jan. 21, Obama proposed limiting banks' ability to engage in proprietary trading. On its face, this could hurt exchanges, as anything that restricts trading could limit profits.
But, says Keefe, Bruyette & Woods (KBW) analyst Niamh Alexander, the rule will be hard to implement, and hedge funds and other players could easily replace those forced to stop trading. "I don't think that impacts volume," she says.
Whenever new rules take effect, they could require more red tape and higher legal bills, but they won't necessarily hurt trading activity, Tabb says. "The congressional rules are very far-reaching, but I'm not sure they harm the markets."
Investors will breathe a sigh of relief when and if the details of financial reform are finally set. Even if that occurs soon, though, other questions are bothering exchange investors.
More Interest in Options
Scott A. Armiger, a portfolio manager at Christiana Bank & Trust, sold his stake in Nasdaq on Jan. 27, partly on worries that equity volume could be sluggish this year. While 2008 and 2009 were wild and volatile years for stocks, 2010 could be far more boring. "We didn't think this year was going to be a big up or down year for the equity markets," Armiger says.
For derivatives exchanges, much depends on the direction of interest rates. Options linked to interest rates make up much of the CME's volume. KBW's Alexander expects option traders to get busy later this year in anticipation that the Federal Reserve will raise rates. "That's going to be really good for CME," she says, while predicting tougher growth prospects for volume on equity exchanges this year.
Yet a rise in interest rates will occur only if the economy is strong this year—an expectation not all investors share. A weaker-than-expected economy is one reason Lancz says he is being careful about adding to his exchange holdings.
Even if interest rate changes or rising investor confidence can boost trading volumes, established exchanges must fight off fierce competition from such low-cost exchange operators as BATS Trading. Founded less than five years ago, BATS executed 10.2% of U.S. stock trading last month—compared with 26% for NYSE and 24% for Nasdaq. And this month, BATS is launching an options exchange, hoping its cheap trading will win market share away from CME and other derivative exchanges.
Those who hold exchange stocks insist their long-term prospects are good, especially as they seek growth outside the U.S. Eventually, financial regulations will be set and markets will return to normal, they say.
"This is one that is going to take more time to germinate and bloom," Frost's Ted Harper says of his holding in NYSE. "We're willing to be patient."