#$rem

After breaking out of a massive cup-&-handle formation last month, REITs have returned to test that breakout level.

Early on in the week, a theme has definitely begun to emerge: “tests”. No, not the “back to school” variety but tests on the charts of financial markets. By chart tests, we are simply referring to occasions in which prices revisit former levels of significance and either confirm or reject previous action. If prices hold the level and resume course in the same direction as their prior encounter with the area, we say the test was successful. However, if prices move through the level in question, the test is a failure.

Over the past week, we have noted key chart tests of all varieties and durations. Utilities are testing their breakout level of last spring while, as noted yesterday, German stocks are testing their breakout of just a few weeks ago. Somewhere in between, we have a plethora of sectors and markets, e.g., the S&P 500, that broke out above significant levels in early to mid-July. Some of these groups are returning now to test those important breakout levels. Included among them are Real Estate Investment Trusts, or REITs.

On July 12, we noted that one of the main REIT indices, the Dow Jones U.S. Select REIT Index was not only breaking out to all-time highs, but it was arguably emerging from a historically uber-bullish chart pattern as well. The chart pattern is a “cup-&-handle” and typically leads to meaningful moves higher upon breaking out above its former peaks. After the breakout, the index was able to follow through to the upside by about 4% over the next 3 weeks.

Over the past 3 weeks, however, REITs have done an about-face, steadily pulling back to the point where they are presently testing the level of their July breakout.

As we noted in the July post, 2 of the largest REIT ETF’s in the market were essentially tracking the index step for step. That continues to be the case. Here is the SPDR Dow Jones REIT ETF (RWR):

And here is the Vanguard REIT ETF (VNQ):

Like other similar posts recently, the game plan ought to be pretty simple regarding such a test. Should prices hold the breakout level, longs should have the advantage. And considering, again, the cup-&-handle pattern from which this breakout came, with a successful test under the belt, REITs could have extensive upside potential. On the other hand, should prices be unable to hold the breakout level, we’d be looking at a false breakout. And as we’ve seen plenty of times in recent years, false breakouts or breakdowns can lead to just as powerful a move in the opposite direction.

One “wildcard” in this instance may be S&P’s reclassification of real estate as its own sector beginning August 31, 2016. The decision to move real estate out of the financial sector has led to plenty of speculation as to what will transpire. We’re not about speculating, though. We prefer to analyze the charts and the data and make investment decisions based on objective, quantitative strategies. Our belief is that all market pertinent inputs will necessarily be filtered through the data and through prices on the charts. Thus, investors need only to concern themselves with what is happening in the charts and data, rather than what supposedly caused the happening.

Thus, in this case, regardless of the impact of the S&P reclassification, the only thing that matters in the immediate-term is that REITs successfully hold the territory near their July breakout.

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More from Dana Lyons, JLFMI and My401kPro.

An index of U.S. REITs just experienced a potentially major breakout from a decade-long bullish chart pattern.

Following what we viewed as the popping of a likely real estate bubble in 2006-2007, our guess was that, after a dead-cat bounce, the sector would be dead money for some time. Almost 10 years later, apparently we thought wrong. Whether we are witnessing an echo bubble or whatever, real estate money is alive and well on some fronts. One such area has been Real Estate Investment Trusts (REITs). Now it is certainly arguable that REITs have been artificially propped up by the low-rate (or no-rate) environment and its accompanying affordability, access to deal financing and attractive dividends relative to fixed income instruments. Whether that’s indeed the case or not, though, we don’t care. All that matters to us is the fact that a major U.S. REIT index has just hit an all-time high -- and in the process, has broken out of a potentially very bullish decade-long chart pattern.

The index is the Dow Jones U.S. Select REIT Index. The chart pattern arguably in force on the chart is a “cup-&-handle”. We have discussed this pattern in other posts in the past, including the fact that it typically is considered to be a bullish pattern. What does it look like and why is it bullish? The pattern involves 2 parts, generally showing the following characteristics:

The Cup: This phase includes an initial high on the left side of a chart (in the beginning of 2007, in this case) followed by a relatively long, often-rounded retrenchment before a return to the initial high (in January 2015).

The Handle: This phase involves a shorter, shallower dip in the security and subsequent recovery to the prior highs (last month).

The bullish theory is predicated on the idea that after taking a long time for a security to return to its initial high during the “cup” phase, the “handle” phase is much briefer and shallower. This theoretically indicates an increased eagerness on the part of investors to buy the security since they did not allow it to pull back nearly as long or as deep as occurred in the cup phase. Regardless of the theory, the chart pattern has often been effective in forecasting an eventual breakout and advance above the former highs. And indeed, the Dow Jones U.S. Select REIT Index has broken out to new highs over this past month.

So how far does the pattern imply the index might rally after the breakout? That is certainly more of an art than science, but various technicians argue for a 50%-100% extension of the range of the “cup”. In this case, the cup ranges from a high around 100 to a low of 21.60 in 2009. Therefore, the range is about 80 dollars.

Based on the 50%-100% rule of thumb, if successful, the recent breakout would suggest an advance of 40-80 above the top of the range. That would be an extraordinary move, especially given the latter stages of the market cycle. Speaking of latter stages, we have warned many times about the market’s recent propensity for “false breakouts”. This is something to watch for in the event that prices do drop back down to (or below) the breakout point near 100.

Incidentally, it is not just the index that is breaking out above a potential decade-long cup-&-handle. Two of the most popular REIT ETF’s also share that same look as the Index.

First off, here’s the Vanguard REIT ETF (VNQ) breaking out of a post-2007 cup-&-handle.

Similarly, the SPDR Dow Jones REIT ETF (RWR) has just broken above its own potential 10-month cup-and-handle .

So what is the bottom line? While we remain leery of the aging equity bull market in the longer-term, in the near to intermediate-term, there is nothing more bullish than new all-time highs. Thus, until prices fall back below the breakout level, expect REITs to remain constructive -- and perhaps blow the roof off.

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More from Dana Lyons, JLFMI and My401kPro.

REITs, one of the hottest sectors in the market right now, may be running into chart resistance.

The popular saying goes that real estate is all about location, location, location. So it can also be said about price charts. The proximity of a stock, index, etc. to the important lines of potential support and resistance on a chart fully dictates the desirability of investing in that security at a particular time. For example, consider the chart of one of the hottest sectors in the market over the past 3 months --REITs.

REITs, or Real Estate Investment Trusts, have been on a tear since February. In just the past few days, REITs have accelerated their advance, hitting new 52-week highs (thanks to bullish remarks by popular punditry). But while REITs’ relative strength is not in doubt, there are certain spots on the chart that may serve to slow down the advance. The sector may be at such a spot now, as judged by the Dow Jones U.S. Real Estate Investment Trust Index.

As the chart shows, while the recent break to new rally highs is a positive, the move has led the index squarely into potential resistance, in the form of 2 significant trendlines:

The Down trendline from REITs’ all-itme high in 2007, connecting the early 2015 high, and

The bottom side of the post-2009 Up trendline, connecting the 2013 and 2014 lows; this line was broken last June and successfully defended on 2 subsequent occasions.

We don’t know it these trendlines are going to stop, or even slow down, the REITs’ momentum. However, as we stated, it is important to understand and be aware of price’s proximity to potentially important lines of support and resistance. In this case, while the short-term action has been stellar, it is helpful to put it into the big picture context. Not only is the index continuing to put in lower highs on its long-term chart, but price is hitting 2 significant trendlines.

Again, we don’t know if this “resistance” will hold prices down, even temporarily. However, if one is considering chasing this rally, it may be useful to apply the old real estate saw -- charts are all about location, location, location. And in this case, the property above the 2 aforementioned trendlines is much more desirable real estate for REITs owners.

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More from Dana Lyons, JLFMI and My401kPro.

As a value investor, I’m a little frustrated these days. There is virtually nothing cheap anywhere in the public markets. Stocks are expensive, trading at cyclically-adjusted price earnings ratios higher than those before the 1929 and 2008 crashes. And the 10-year Treasury yield — even after its recent surge — is barely 0.4% above the core inflation rate.

Yet there is one corner of the market still showing signs of value: mortgage REITs.

I wrote earlier this year that mortgage REITs as an asset class were trading at some of the steepest discounts to book value in history. Well, as we round out the first quarter, very little has changed on that front. Even as earnings and revised book values have come in, valuations haven’t changed much. 

Consider the chart above, which details the top ten holdings of the iShares Mortgage Real Estate Capped (REM). The mortgage REIT universe is small, and the top ten holdings make up 68% of the total portfolio. Two mortgage REITs alone — Annaly Capital (NLY) and American Capital Agency (AGNC)— make up about 30% of the portfolio. 

We see a common theme throughout the top ten holdings. This is one of the few remaining truly high yield corners of the market, and the top ten holdings have a weighted average yield of 10.4%. 

But what interests me more are the large discounts to book value. The top ten holdings trade for 97 cents on the dollar. But Annaly and American Capital Agency trade at even deeper discounts, 81 cents and 83 cents on the dollar, respectively. 

Let me put this into perspective. You could hypothetically buy up all of the shares and close the two mortgage REITs, selling their assets as spare parts, and still make a respectable profit of 19% and 17%, respectively. 

The market seems to be pricing in major capital destruction by their respective managements. But is that fair? Annaly in particular has a long operating history, and it has survived every conceivable bend and twist in the yield curve over the years. Granted, our situation today — one in which short-term rates are at zero and mortgage rates near all-time lows — is unprecedented. But at these discounts to book value, the market is practically gift wrapping a massive margin of safety for us. 

Let’s take a look at Annaly’s historical price/book ratio to get a little perspective.

For virtually its entire history as a publically-traded mortgage REIT, Annaly has traded at a significant premium to book value. This makes perfect sense. Annaly can borrow much cheaper than you or I could and has economies of scale that we don’t. Investors pay for that in the form a premium to book value.

But something strange happened in early 2012. The price fell below book value, where it has stayed ever since. Investors feared that a flat yield curve and falling mortgage rates would crimp profitability and force Annaly to cut its dividend. And this has indeed proven to be the case. Annaly cut its dividend twice in 2012 and twice again in 2013. But at current prices, Annaly and its peers have been more than adequately punished for their dividend cuts, come what may with Fed policy and mortgage rates. 

In late January, I suggested that mortgage REITs should aggressively repurchase their shares. Rather than buy low-yielding mortgages — or slide down the credit quality scale to chase yield — mortgage REITs trading at discounts to book value should absolutely repurchase their own shares. It’s the only sensible thing to do. 

If Annaly — and the rest of the mortgage REITs trading at deep discounts to book value — care about the best interests of their shareholders, they will aggressively buy up their own shares on the open market as their portfolios of mortgage securities roll off. 

If you don’t buy your own stock at 80 cents on the dollar, then when would you? 

Disclosures: Long NLY, REM 

Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.

The prevailing wisdom on real estate investment trusts (REITs) is that they’ll be doomed once interest rates start to rise. Because of the way REITs are structured for tax purposes they have to pay out at least 90% of their taxable income in the form of dividends.

The thinking goes that higher interest rates will provide competition against the yields on REITs, making them less attractive. I’m never one to take rules of thumb at face value so let’s see how this theory worked in past rising rate environments.

The Wilshire REIT Index goes all the way back to 1979. Here’s how this index performed during prior rising interest rates environments:

In four out of the six periods where rates went substantially higher, REITs were actually positive. And in three out of the four positive time frames they showed outstanding performance.

If REITs were sensitive to interest rate moves, you would also expect them to be highly correlated with bonds. This hasn’t been the case. From 1979 to mid-2014, the correlation between the Wilshire REIT Index and the Barclays Capital Aggregate Bond Index was 0.02, signifying no relationship in price movements in that time.

As I’ve pointed out before, these relationships are never static over the years as the market environment is constantly evolving so it makes sense to look at the change in correlations over time. Here’s the rolling 5 year correlation between REITs and bonds from the inception of the Wilshire Index:

There are times when the two asset classes moved together in the past but there’s not much of a discernible pattern here. REITs are actually more strongly correlated with stocks. The S&P 500 has a correlation coefficient of 0.40 with REITs over the same time frame. But that relationship changes as well:

These changing relationships between asset classes can make it difficult on investors, but for a diversified portfolio this is actually the kind of behavior you would like to see. For inclusion in a portfolio, a long-term investment should generally have an expected return above inflation and not move in lockstep with the other asset classes selected.

It would be a mistake to compare REITs and bonds simply because they’re both income-producing assets. REITs are much closer to stocks in terms of the risk-return profile. Here are the largest annual losses for the Wilshire Index: -39.2%, -23.4%, -17.6%, -17.0% and -6.6%. Interestingly enough, REITs have outperformed stocks and bonds since 1979:

There are a few caveats that apply here. There weren’t many REIT funds available during most of this performance history. Vanguard’s REIT fund wasn’t available until 1997.

Plus, the total market value of the REIT sector is fairly small compared to the entire stock market. While the total value of the commercial real estate market is roughly the same size as the U.S. stock market, it’s not easy to invest in the all of these properties. As of 2013 there were only about 200 REITs available to trade at a market value of over $700 billion.  But REITs actually make up about 2% of the S&P 500 so most investors probably have some exposure to them already.

REITs are up almost 15% this year so it’s possible they could be sold as investors look elsewhere for gains. There’s no guarantee that REITs will perform poorly if rates ever do have a sustained rise. It’s also likely that inflation will pick up as well, which would allow the management companies of the REITs to increase the rents on tenants. Even though the historical record during rising rate environments looks promising, investor preferences going forward are the only thing that matters, as always.

This post from Ben Carlson (@awealthofcs) originally appeared on A Wealth of Common Sense.