Macro Trends in Technology and Banking

Published by clickbroker.blogspot.com.

I would like to convey some macro trends in two of the most volatile and perceived economically risky sectors of the S&P 500. My analysis is primarily anecdotal, without taking a deep dive into the numbers.

Macro Trends in Technology
Apple (AAPL), Amazon (AMZN), the cable companies and “brick and mortar” book stores are taking a deep dive into the transition from physical to virtual content. Both sales of files and rental of streams are being heavily promoted. Bloomberg Businessweek’s "Intel Wants to Be Inside Everything" and “Don't Rule Out Apple Ruling Your Living Room” discuss the implications. Most analysts view this mass virtualization as a boom to the current entrenched innovators; too risky for me at their current stock prices.

The key takeaways from the Bloomberg articles is that Intel’s (INTC) low cost Atom processors are being embedded into all types of consumer devices (beyond entertainment) and Apple is building a billion dollar data center in North Carolina. This indicates that virtualization is requiring a huge investment in very physical, massive server farms. Intel said during its last earnings call that the economics are compelling for a server refresh cycle based on energy costs alone. Couple this with reduced form factors makes for a very short payback cycle.

I think Intel and Cisco (CSCO) will be the primary benefactors of this technology trend. The “box makers” and storage vendors face cut-throat competition. HP (HPQ), IBM (IBM) and Oracle (ORCL) are too diversified too get a big lift from the trend. Startups will be evolving to package Intel processors into denser and more energy efficient configurations. In Warren Buffett’s terms, the moat around Intel is too great for startups to penetrate its core. And the Atom processor might eventually dominate the mobile market; a dream I admit.

Cisco is concentrating on servers for the communication market, taking advantage of its primary market concentration. Cisco has a history of acquiring any technology needed to dominate. They can create a moat around specialty servers by optimizing data transmission. Cisco can out fox Dell (DELL) and the other server providers while leaving room for startups to innovate. Once innovators pass concept, Cisco will either copy or acquire them.

The Intel tale is based on the recurring revenue models of utility companies and software maintenance. Larry Ellison said you buy software companies to capture the recurring revenue. Intel is telling us that the server replacement cycle will shrink from up to a decade to just a couple of years going forward. Imagine the revenue impact if processors are replaced every two years in the large server farms.

Macro Trends in Banking
On the negative side Bank of America (BAC), JP Morgan (JPM) and Wells Fargo (WFC) are being asked to buy back residential mortgages that did not meet their warranty claims. This involves real cash payouts in addition to write downs in their own portfolios. Maybe their acquisitions were not such a bargain after all. Goldman Sachs (GS) is getting hit with slower activity and trying to be a good citizen in light of FinReg. New credit card and consumer regulations present challenges for Citigroup (C) and friends to redistribute fees among customers.

Regional banks face the additional problem of lending long with short term interest rates so low. Higher rates would actually loosen credit to all but the largest business. The borrow short and lend long is deadly in this environment, so banks are parking money in 1 to 3 year Treasuries, Agencies and excess Federal Reserve deposits.

But anecdotally the inverse trend seems to be developing; borrow long and lend short. The new regulatory focus on liquidity, in addition to capital, has banks extending the maturity of their wholesale funding and term debt. The Fed is providing a once in a lifetime opportunity to extend maturities for up to 15 years at a market rate of about 5%. The largest banks appear to be giving up short-term profits with near term funding for stability and assured liquidity. Investment banking activities of the largest banks can absorb the higher cost of financing and still be profitable.

The borrow long, lend short model favors the world’s largest banks. I see Bank of America, Barclays (BCS) and Goldman offering bonds ranging from 5 to 15 years to retail investors. What I don’t see is the large US regional banks participating. Many regionals have more deposits than they can lend so they cannot profitably invest 5% money without substantial credit and interest rate risk.

This means that the largest banks stand to be substantially more profitable than the regionals when interest rates start to rise. To copy the old Philadelphia college basketball league, the “Big 5” will see their 5% funding become a consistent profit generator over the next decade while the regionals have to pay up.

While all banks will benefit from rising rates, the interest rate margins will certainly favor those banks that can lock in funding now. Being the “Big 5” dominates the Financial Select Sector SPDR (XLF), this would be the best way to play the trend. Improved liquidity and more conservative operations lead to a much more secure, be it slow growth, investment thesis.

Note: The Philadelphia Big 5 includes La Salle, Penn, Saint Joseph's, Temple, Villanova. My banking Big 5 includes Bank of America, Citigroup, Goldman, JP Morgan and Wells Fargo. I purposely left out Morgan Stanley (MS).

Disclosure: Author is long BAC, BCS, C, INTC and WFC.

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