Severe but short trading drop on horizon

NEW YORK (Reuters) - After a panicked few months of record selling, the world's stock traders are walking away from equity markets and are not expected to return in force until 2010.

Fewer participants signals a drought for companies that rely on trading volumes, such as online brokerages and exchange operators, both of which have benefited from a spike in volume brought on by the volatile selloff.

Because the selloff was so sharp, market observers expect the decline in trading volume to be severe but short -- unlike early this decade, when U.S. equity trading volume took three years to follow the broader market down.

"What you're seeing is an extraordinary phenomenon where liquidity just blew out to unprecedented levels," said Laurie Berke, senior consultant at research and advisory firm TABB Group and author of its soon-to-be-published U.S. Institutional Equity Trading study.

"The liquidation has been far greater, equity assets under management have shrunk far more rapidly, so therefore I think the impact on volume happens much faster, and it's in 2009," she said in an interview. "You don't wait until 2010 for that to happen."

It took nearly three years for the dot-com crisis to decimate stocks the way the credit crisis has in less than a year.

While the S&P 500 index .SPX skidded from 2000 to 2002, average daily volume continued to rise. It wasn't until 2003, when the S&P rebounded 26 percent, that volume finally declined, by 3 percent.

"We could have a lower volume period throughout much of 2009, until the market begins to see the light at the end of the tunnel," Berke said.

LIQUIDATION FOR EVERYONE

A 39 percent decline in the S&P 500 since January has meant liquidation for everyone.

Hedge funds have deleveraged and contracted, banks have consolidated and eliminated jobs, and individual investors have dumped equities for cash and safer securities.

Like the technology-inspired downturn of 2000-2002, the current mortgage-inspired downturn is expected to first drive individual investors, known as retailers, away from actively trading. That could further handcuff institutions, which often rely on retailers to take the other side of their trades.

"When the retail guys begin to go away, suddenly all you have is very knowledgeable players playing with each other, and it gets a little dicey," said Brad Hintz, analyst at Sanford C. Bernstein, who expects trading volumes to decline until 2010.

Analysts are lowering trading forecasts, and companies in the United States and elsewhere are trying to manage expectations for an unpredictable year ahead.

TD Ameritrade (AMTD.O), the No. 2 U.S. online brokerage, said it expects a trading decline of up to 14 percent next year. Ameritrade and its peers logged a series of trading records as volumes for U.S. equities exploded in September and climaxed at the height of the selloff in October, before quieting somewhat last month.

Richard Repetto, analyst at Sandler O'Neill, expects industry leader Charles Schwab Corp (SCHW.O) to undergo an average daily trading drop of no more than 35 percent next year, adding in a note to clients last month that predictions in these "fast moving, changing market conditions have been difficult."

HIGH-SPEED CYCLES

Repetto and others have also reduced price targets and earnings estimates for NYSE Euronext (NYX.N) and Nasdaq OMX (NDAQ.O), which respectively operate the New York Stock Exchange and Nasdaq Stock Market.

The transatlantic companies each derive about 25 percent of their net revenue from U.S. trading, and their shares have been stung by expectations of pain in 2009.

"Our view, especially on the exchanges, is that they've been extremely over-penalized," said Roger Freeman, analyst at Barclays Capital who covers both exchanges and online brokers.

"The market is far more institutionally driven than it used to be, and within the institutional space there are a lot of algo-driven strategies that don't require leverage."

Indeed, trading has been transformed in the last few years, which could hasten both the drop and the recovery in volume.

Computerized trading programs, called algorithms, now generate up to 40 percent of all activity, according to one recent study by U.S.-based research firm Aite Group.

Even the retailers -- who now can cheaply access markets and the information necessary to trade there -- are increasingly using sophisticated products such as options.

"Higher volatility and higher trading volumes is the new reality. This is not a two-month thing," said Keith McCullough, CEO of Connecticut-based research and advisory firm Research Edge.

"Wall Street has never been shaken to its core like this, ... so I think that when we come back next time there is a massive tidal wave of self-direct investing coming that's going to increase volume."

(Editing by John Wallace)