Mortgage REITs Can Now Recover

 | Jan 13, 2014 | 10:00 AM EST
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Real estate investment trusts, known more commonly simply as REITs, come in many shapes and sizes. One area that has stirred investors' interest in recent weeks focuses upon the mortgage REITs. This subsector includes companies such as PennyMac (PMT) and Redrood Trust (RWT). Both experienced sharp selloffs earlier this past year as mortgage rates plummeted.

At the same time as these mortgage REITs fell apart, Treasury bonds fell sharply as well. The reason behind this correlation is that many mortgage-backed REITS will fund themselves for the short term and buy longer-dated mortgage-backed securities and debt from U.S. agencies such as Fannie Mae (FNMA) and Freddie Mac (FMCC). So, funding costs increase while the value of the securities they hold declines.

At present, Treasury bonds are finally showing a strong support level and a momentum shift on the daily and weekly time frame. In other words, the pace of the selloff has slowed to a degree that positions it for at least a short-term recovery. As such, the mortgage REITs, which have been positioning themselves defensively again upcoming mortgage rate hikes, now stand a chance to benefit as well.

iShares 20+ Treasury (TLT)
Source: TradeStation

My favorite mortgage REIT, and one in which I'm currently starting to build a position, is Two Harbors Investment (TWO). The company focuses on investing in, financing, and managing residential mortgage-backed securities (RMBS), residential mortgage loans and other financial assets. With a diversified portfolio and a dividend that has been averaging between 10-12%, it's hard to overlook.

The first thing that caught my eye on Two Harbors was its monthly chart. Over the past two years, it experienced a strong rally and equally strong reversal that has returned its shares to early 2012 congestion levels. This inverted-V formation on the monthly time frame was followed by a slowdown in the pace of the selling as the prior congestion level hit. By retesting that level a second time on even more gradual momentum, the security is undergoing a momentum shift that is favorable for the development of a bottoming pattern.

Two Harbors may still be in the early stages of this bottom, but I feel that the increased upside compared to downside momentum and the fact that it has already retested last year's lows once will help limit the downside risk as a longer-term investment.

Volume activity in Two Harbors is also suggestive of major support. Volume spiked in mid-2013 as the company's selloff gained momentum. But that spikedid not occur at the 2013 lows. Instead, when Two Harbors fell to a lower low in the third quarter, testing support more securely, the volume did not spike a second time. This typically indicates that most of the panic selling has passed and it is an initial sign of a real bottom developing. The lighter volume on the retest of that low continues to confirm this bias, making the current price levels at this monthly support ideal for position building.

While Two Harbors is my favorite company in this group, a more recent IPO us worth a look. Newcastle Investment (NCT) has been trading in a range since its initial public offering, but the momentum within that range has also been shifting favorably on side of the bulls. Newcastle is currently at the upper end of its monthly trading channel, but this is the third major test on the monthly timeframe and it has a higher chance of breaking that resistance this time around. My short-term target on Newcastle is about $6.20, but like Two Harbors it is also of interest as another diversification measure in a longer-term portfolio.


Newcastle (NCT) -- Daily
Source: TradeStation

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