How The Fiscal Cliff Fix Fails NLY And AGNC

| About: Annaly Capital (NLY)

Annaly Capital Management (NYSE:NLY) and American Capital Agency Corp. (NASDAQ:AGNC) both soared with the market in the first two days of trading since the fiscal cliff resolution. Still, I think the deal in D.C. will actually work against NLY and AGNC shares on net, as capital flows find riskier assets. As a result, NLY and big dividend paying peers like AGNC could see shareholders stray in search of growth names. I do not believe the latest market concern about lightening Federal Reserve support will hold stocks down over the next few weeks, as rising rate fears are built upon an expectation of economic expansion and not detached inflation.

While traders cheered at the corner of Wall and Broad Street Wednesday, and the market soared with the SPDR S&P 500 (NYSEARCA:SPY) climbing 2.6%, the shares of Annaly Capital Management and American Capital Agency also climbed. NLY gained 2.0%, which is a big move for a stock that has been relatively stable over the last few years. American Capital Agency soared even higher, rising 4.6% on the day. As the rally aged into a second day of trading, NLY and AGNC gained another 1.2% and 1.0%, respectively, against the SPY's 0.2% decline.

It's my view, though, that what has investors buying stocks of all sorts since the fiscal fix will also guide investment capital from NLY and AGNC as a finer screen prevails. No longer will money seek the safety of the dividend yield and fixed income stream. A market still fueled by fiscal stimulus and supported by a reviving economy should favor growth over value. Investors may even stray as far as to low-quality shares if stimulus finally results in better than recent GDP growth. While there will always be a group of investors who need an income stream like that which NLY provides, many of the buyers of mortgage REITs these days include other investors who have simply sought some safety. But, when the rain stops falling, it should seem nicer to those investors to be exposed rather than under cover. So capital support of the mREITs should wane.

NLY's beta coefficient of 0.06 and AGNC's 0.17 illustrate the uncorrelated nature of mortgage REITs to the broader market. So the rise of the shares with the market over the past couple days was uncharacteristic of normal behavior. But on Wednesday, many assets were correlated as they moved to the upside, with the SPDR Gold Shares (NYSEARCA:GLD) and the iPath GSCI Crude Oil TR Index (NYSEARCA:OIL) rising as well. It was similar to the action of securities and assets during the financial crisis, when all assets declined at the same time. These days, institutions dominate the market and when they put capital to work or take it out of action it spreads across securities. In times of panic and euphoria, that effect is exaggerated.

On Thursday afternoon, after the minutes of the Federal Open Market Committee (FOMC) were published, stocks retreated, but NLY and AGNC stayed in the green. Stocks declined because of the comments of Fed officials revealed within the minutes, through which some committee members expressed opinions indicating asset purchases could be concluded before the end of 2013. This raised concern that the Fed's promise to keep rates low might not hold for as long as the market had previously anticipated. If interest rates rise, the cost of capital increases for companies and returns are squeezed. If operating returns are squeezed, so should share prices find obstruction to their growth.

However, it would happen due to economic expansion, as the expectation of the FOMC is not for stagflation or detached inflation but for healthy price increase. My view is different, but for the purposes of this article and its near-term forecast, we'll hold to that assumption. So basically, the market sold off Thursday on good news - for a growing economy. But why did NLY and AGNC retain investor support?

It's because they continued to pull in capital seeking the return provided by their substantial dividend yields. NLY offers a yield of 12.8% and AGNC returns a dividend yield of 17.3%. However, I'm sorry to tell you that rising interest rates will squeeze the operating profits of mortgage REITs in a profound manner, and so these companies should not be attracting capital if rising rates are the premise of the strategy. I discussed the risk associated with mortgage REITs in past articles. Mortgage REITs are often offered to seniors because of their income stream, but I questioned whether the securities were appropriate for seniors in a two part series (Part I & Part II), because they are not without risk.

So in my opinion a finer screen should drive capital out of NLY and AGNC, no matter whether inflation accompanies economic growth or not, because each should affect capital support of the shares in their own way, as detailed herein.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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