Return of Confidence

Terry Flanagan

Investors wait for some semblance of clarity to return to the markets before regaining confidence.

“The markets right now are predominantly driven by geopolitical and policy risk,” said Jamie Selway, managing director at ITG. “The political environment has so much uncertainty around what policy makers will and won’t do. That needs to be removed before the markets will head to higher levels and feel more stable.”

A slew issues have led to uncertainty in the marketplace. Regulations, including Dodd-Frank and the Volcker Rule, threaten the way the big Wall Street banks operate. Similar regulations are being proposed in Europe as well, in the form of Mifid. Political uncertainty also looms, with an election coming up and the potential of another round of Quantitative Easing.

“If you talk to investors right now, it’s frustratingly difficult to trade,” said Selway. “If you are an investor in bank stocks, it’s not about the economic fundamentals of the company, but how Dodd-Frank will impact them. Risks are so tilted toward regulatory and geopolitical issues right now, it’s hard to investors to trade. Anything that removes the political and regulatory risks from the economy would be quite beneficial and people can get back to business. Corporate America can invest, banks can begin to extend financing for risk projects. Investors will be able to think about companies from a fundamental perspective and not a regulatory or geopolitical perspective.”

While many of the big broker-dealers have been taking it on the chin in recent months, a resurgence in fixed-income and a stronger IPO market have provided a much needed boost. Thus far in 2012 the Wall Street banks and brokers have performed well, and are largely expected to post solid numbers from their capital markets units when fiscal first quarter financials are released.

Knight Capital has been among the first of the major brokers to release their financials, and it performed better than estimates had expected, on the back of the strong performance of its market making institutional sales and trading and electronic execution services. However, its success the remainder of the year will depend largely on the prevailing market conditions.

Knight is “very sensitive to market conditions for its core equity trading business,” said Richard Repetto, analyst with Sandler O’Neill. “With a significant portion of order flow coming from online brokers, Knight could be hurt by any decline in the trading activity of retail investors or loss of significant customers. In addition, revenue capture at Knight’s core market making business could deteriorate.”

Market volatility has been relatively low through the first quarter of 2012, as the Chicago Board Options Exchange Volatility Index showed. It has remained below 20 for most of the year thus far, absent a handful of short-term spikes. Two and three percent intraday swings became the norm during the second half of 2011, culminating in a high of 48 seen on August 8. The volatility late last year came in the wake of a slew of macroeconomic events, including the European debt crisis and the U.S. debt downgrade. As of April 18, the VIX was trading at about 18.

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