Shares of Charles Schwab, LPL Financial, Raymond James Financial, and other wealth management companies saw significant declines on Tuesday, outpacing the broader market.

Investor apprehension can be attributed to several factors including concerns regarding cash sorting, the future of investment banking in some firms, and the impact of recent stock market downturns on client assets at wealth management institutions.

According to Michael Wong, an analyst at Morningstar, "Wealth management firms' profitability is directly linked to client assets, which have suffered due to the recent volatility in the stock market."

On Tuesday, the S&P 500 fell by 1.4%. Charles Schwab (SCHW) was one of the most affected, experiencing a 4.2% decline in their share prices. LPL (LPLA) and Raymond James (RJF) also faced losses, with drops of 3.2% and 1.9%, respectively.

Other companies heavily involved in wealth management were similarly impacted. Morgan Stanley (MS), the parent company of E*Trade and home to numerous financial advisors catering to wealthy clients, observed a 3% decrease in their stock value. Stifel Financial (SF) was down 4.2%.

Cash sorting, a process that involves customers transferring idle funds from low-interest bank accounts to higher-yielding alternatives, has been a persistent concern for wealth management firms over the past year. Charles Schwab has been particularly affected.

Many Schwab clients have redirected their cash from bank accounts into money-market funds offered by the company. If the outflows from these bank accounts exceed Schwab's available cash, they have to resort to costly measures to bridge the gap. Earlier this year, Schwab's stock experienced a substantial decline due to the regional bank crisis. Although it managed to recover partially, it is still down by 38% in 2023.

According to S&P Global Market Intelligence, Schwab's deposits have decreased by 31.1% year over year, amounting to $304.79 billion as of June 30. This marks the largest percentage decline among the top 15 U.S. banks in terms of deposits.

Schwab executives have stated that the pace of cash sorting has slowed down. Michael Wong from Morningstar believes that most investors who had surplus cash have likely already completed their transactions during the past year. "I believe we are nearing the end of this cash-sorting cycle," he explains.

Winding Down Cash Sorting: A Shift in Focus

Devin Ryan, an analyst at JMP Securities, acknowledges that the process of cash sorting is gradually coming to an end. However, the potential for interest rates to remain high has redirected investors' attention to a matter that was previously fading into the background. "There was optimism that we were reaching the final stages of cash sorting, but with rates expected to stay elevated for longer, people are now looking to explore alternative options for their excess cash," notes Ryan.

The impact of investment banking concerns cannot be ignored, particularly for companies like Raymond James and Stifel, which operate both investment banking and wealth management units.

Over the past 18 months, the surge in interest rates has taken a toll on investment banking activity. However, there was a glimmer of hope when several major names decided to go public, including Arm Holdings. "During the summer, there was some optimism that green shoots were emerging and a recovery was on the horizon," explains Ryan. According to KPMG, companies have managed to raise approximately $18 billion through initial public offerings (IPOs) this year. While this figure is lower than last year's $23 billion, it pales in comparison to the record $300 billion raised in 2021.

Unfortunately, recent market declines have dampened the prospects of any emerging green shoots. "Choppy markets create a challenging environment for companies trying to raise capital or conduct an IPO," observes Ryan. "It also hampers companies' ability to make significant decisions such as acquiring another company."

The volatility of investment banking revenues from one quarter to another highlights the need for a balanced approach. Morgan Stanley CEO James Gorman, recognizing this, has sought to combine investment banking with a robust wealth management business to generate more consistent revenue.

The decline in wealth management stocks has also affected related companies like Envestnet, a provider of technology and asset management services to financial advisors. Envestnet's shares have dropped by 3% as the company struggles to meet analysts' revenue estimates for the second quarter. In fact, Envestnet's stock has plummeted by 33% this year, leading the company to announce upcoming layoffs.

Ryan attributes the selling pressure in wealth management names to the broader macroeconomic environment and its impact on the sector as a whole.

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