The simple answer is that down markets are bad for trading volume, not to mention margin lending, which has been a big source of profits for online brokers. And until the clouds hovering over the market pass, it may be wise for Internet investors to steer clear of shares of the companies that are nearest their hearts: online-brokerage firms.

It doesn't take a rocket scientist to understand why online-broker stocks have been slammed so hard lately. After all, investors trade more actively when the market is chugging upward. "The simple truth is that investors trade more when they feel good," says Steven Galbraith, an analyst at Sanford C Bernstein. "It really is that simple." Indeed, trading volume was so high earlier this year when the Nasdaq was charging to new highs that online brokers were posting record profits at the same time they were reducing their prices per trade for investors.

Don't count on that continuing, however. Few on Wall Street expect the unusually heavy trading volume of the first quarter to continue. For one thing, trading usually hits a seasonal slowdown in summer. And if market conditions don't improve, trading volume could fall off even more dramatically, analysts say. "This kind of volatility is so bone-jarring that it keeps people on the sidelines," says Greg Smith, an analyst at Chase H&Q.

"I expect volume to fall 15 per cent in the second quarter," he says.Right now, it may be tempting to pick up a few shares of online brokers, especially at their current depressed levels.

Ameritrade, for instance, hit a high of around 48 1/8 one year ago. It's now down to less than 17, compared with its year low a few weeks back of 12 5/16. Shares of E*Trade Group have followed a similar track, plummeting from their 52-week high last April of 63 to below 22 now, only slightly above the low of 16 1/16 hit a few weeks back. Knight/Trimark, has fallen from a 52-week high last spring to around 38, up from its low during the recent market rout of 21 11/16. Charles Schwab has held up slightly better, trading above 44 lately. Its 52-week high was 67 1/8, at the end of March and its low of 26 15/16 came last fall.

A positive spin
So far, online brokers are putting the best face on the market's downturn. A Schwab spokesman called trading in recent weeks "calm but active in the face of market volatility." An E*Trade spokesman says volume has been "steady and strong throughout it all." And an Ameritrade spokesman says "customers saw it as a buying opportunity," adding there was "no drop in volume at all."But history has shown that a tumultuous market is bad news for shares of brokers, both full-service and online brokers. "We continue to be surprised that investors are not more questioning about the major retail players' ability to sustain current frenzied levels of activity," Galbraith says.

One more piece of bad news: As much as 20 per cent of online brokers' revenues and even more of their earnings and growth have come from interest on margin loans. If trading volume in Nasdaq stocks falls off, so too may margin lending, which is at record levels. And that will cut into the earnings streams of online brokers, analysts say.

"Without question, higher margin levels have spurred higher levels of trading activity," Galbraith says. He reckons online brokers "may have received fully one-third of their growth from margin and related trading activity."

Not only does that leave the online brokers open to potential losses on margin loans should the market head into a tailspin, but it also could foreshadow a slowdown in earnings growth, he says. "Ascribing price-to-earnings multiples of 50 to what could almost be considered subprime lending operations seems overly optimistic," he says.

Which ones to sell?
For some investors, however, the question isn't whether to own shares of online brokers, but which ones to sell. Chase H&Q's Smith recently upgraded Ameritrade to a "buy" rating from "market perform" because he believes it is pushing into the big leagues with giants Schwab and E*Trade. Indeed, he says, Ameritrade could show 40 per cent growth in new customers in the second quarter, although he estimates Ameritrade will report a loss of between eight cents and four cents a share for the quarter.

Meanwhile, E*Trade is his top pick among giant brokers, and he also likes Knight/Trimark, which he rates a "buy" after it reported a "tremendous" quarter on April 19. "This kind of market volatility is absolutely ideal for them," he says. And Schwab? Though he rates Schwab a "buy," he says he "worries about their valuation relative to the other guys."

Considering the market's recent tumble, "It's not easy to get excited about buying an online portfolio after you just lost 50 per cent of your money," Smith says. "But no one thinks online trading is going away," he says. "This is the wave of the future."

-- The Wall Street Journal