The very foundation of fundamental analysis is the understanding of a company's business, in order to be able to (guess)estimate its underlying intrinsic value and take advantage of currently underpriced stocks. In the field of mREITs, for the broad public it is certainly not easy to fully understand how the business works due to:
- the complex and abstract nature of the financial products being bought and sold: How many retail investors really understand in detail what an MBS (mortgage-backed security) is?
- the high impact of intangible components on the balance sheets
- the high leverage involved
Nonetheless, we could summarize Annaly Capital's (NLY) core business model as follows: The company borrows short-term money at a lower interest rate and leverages it to buy long-term mortgage-related financial products, which return higher interests rates. So, the core money made by Annaly Capital results from the difference (or, technically speaking, the "spread") between short- and long-term interest rates.
On top of that, Annaly Capital's recent strategy was to diversify its activities to become more and more involved in the real estate business. This is why I think it's very useful to benchmark the potential correlation between NLY's prices and the following three values:
- The spread between two-year and 10-year Treasuries rates, as a measure of the difference between short- and long-term rates
- S&P/Case-Shiller U.S. National Home Price Index, as a measure of the health of the U.S. real estate market
- S&P500 Index, as a measure of the health of the broad stock market
Annaly Prices Vs. Interest Rates Spread
Let's start by considering the first of the above values. As shown in the chart below, the spread between the two-year and 10-year U.S. Treasury rates (green line) is close to historical highs.
This is due to the concurrent action of:
- two-year rates (blue line) staying flat at record low values since October 2011
- 10-year rates (red line) bouncing off their low values (May 2012) to the recent value of 3.04%.
Click to enlarge images.
As shown in the chart, the spread (green line) follows a cyclical path and is now very close to its peak, so it can be reasonably expected to drop in the years to come (medium term). How is that more likely to take place? The chart suggests that the short-term rates (blue line) are likely to rise to somewhere little short of 3%, while the long-term rates (red line) can be expected to stay at current levels on average.
What would this scenario mean for Annaly Capital? The company would have to borrow money at higher rates (= higher costs), while the revenues on mortgages would likely remain the same (= same revenues). Overall, this would mean lower earnings for the company. To sum up, this is precisely what is currently scaring the market about Annaly Capital and other mREITs.
Let's take a closer look at the potential correlation between Annaly's price and the spread between two-year and 10-year rates.
Throughout its history, Annaly's price seems to be very well correlated with (although slightly anticipating) the two-year/10-year spread: lows correspond to lows and highs correspond to highs. This held true until May 2013, when an exceptional event took place: Annaly Capital prices diverged from the spread for the first time ever. This key moment (May 2013) was exactly when the debate began about QE3 tapering by the Fed (e.g., the article "U.S. Job Market Gains Could Lead Fed to Taper QE3 Early" from May 19). In my opinion, the key point about Annaly's future is to understand whether the historical correlation with the rates spread will be restored, or if the stock will begin a brand new era and show completely different behavior.
Annaly Prices Vs. National House Price Index
Next, let's look at the possible correlation between Annaly prices and house market prices:
The chart shows no correlation between Annaly prices (red line) and the S&P/Case-Shiller U.S. National Home Prices Index (blue line). In the early years, Annaly rose together with the housing market, then heavily anticipated the burst of the real estate bubble. It then recovered to new highs at the halfway point of the market decline, and stabilized together with the market eventually. Also in this chart a divergence took place: NLY prices were hammered as the housing market recovered.
Annaly Prices Vs. the Stock Market
Last but not least, let's look at Annaly's correlation with the broad stock market (represented by the S&P 500 Index):
In this case, history shows mixed, but regular, behavior. From September 2000 to November 2005, there was an evident inverse correlation: Annaly's highs corresponded to the S&P 500's lows and vice versa. From early 2006 to the end of 2009, a direct correlation occurred: Annaly's and the index's highs and lows corresponded eventually. From 2010 the inverse correlation was restored: a progressive increase followed by a great acceleration for the index, and a progressive decline followed by a great drop in prices for Annaly.
My personal view, as a result of the combination of all the above correlations, is that Annaly Capital 's current prices (close to all-time lows) already fully discounts the current market fears about the impact of rising rates on the company's earning power. Still, I want to believe that Annaly managers already have plans and strategies in place to deal with such a long-awaited and anticipated rise of short-term interests. I believe that history tends to repeat itself. The records for the two-year/10-year spread values show that the two previous lows matched corresponding Annaly price lows, so the market is currently just performing its usual job by anticipating the next low in spreads and already pricing Annaly at lows as a consequence.
This is why my personal expectations for Annaly prices range from substantially flat to a slight rise as the two-year/10-year spread drops, followed by a substantial rise with (or in anticipation of) the next two-year/10-year spread rise cycle. I would not be surprised by the following combination of events: When QE3 tapering is announced, the stock market takes a breath after the recent rally (a correction takes place), short-term interest rates rise, and NLY's price rises.
Living in Italy, it also important for me to add to the scenario the potential rise of the dollar against the euro due to tapering. This is the combined perspective upon which I positioned myself long on NLY for the medium term, and I am ready to collect dividends in the meantime. Of course, only time will tell and everyone has their own views about this.