Trade of the Day: Annaly Capital Management (NLY)

by Jon Markman | January 27, 2014 8:59 am

Stocks came under significant pressure Friday in the wake of fresh concerns about emerging markets and their currencies. The S&P 500 index suffered its biggest one-day percentage decline since June 20, and the Dow Jones Industrials had their first back-to-back declines of more than 1% since April 2012.

The current uneasiness and budding negative sentiment accelerated following Thursday’s double-digit drop in the Argentine peso, and fears of contagion rattled foreign exchange markets overnight. It does not help that China is suffering a manufacturing slowdown, which has caused a decline in demand for the sort of commodities on which most emerging markets depend for export sales.

It’s interesting how investors have gone from a period of not having anything to worry about to panicking about “currency contagion,” a term that had almost vanished from the vocabulary. The S&P 500 Volatility Index (VIX) shot up 31.7% to its highest level since the darkest days of the U.S. government shutdown in October of last year.

My research suggests that Friday’s decline was overdone and is likely to reverse, at least partially, this week. The VIX is likely to fall back to Earth, and some central-bank action over the weekend should help soothe fears on the currency front.

From a technical perspective, the most interesting development was that the S&P 500 Index traded below its 50-day moving average (DMA) for the first time since Oct. 9 of last year. Uptrends are generally defined as conditions in which the benchmark index is above its 50-day average, so people will be wondering whether a new bearish trend is at hand.

However, there was some interesting research published late Friday by analysts at Bespoke Investment Group that throws cold water on those fears. They found that, historically, more often than not, the break below the 50-day after a long period above that level has not been indicative of an imminent sell-off in the S&P 500 index.

In the S&P 500’s history dating back to 1928, there have only been 62 occurrences in which the index closed below its 50-day after trading above it for the prior three months or longer. The returns for the index over the subsequent week, month and three-month period following closes below the 50 DMA for the first time in three months are surprising.

Bespoke reports that the next week has seen an average return of 0.5%, and median returns have been slightly lower at 0.4%. The month following a fresh close below the S&P 500 index’s 50 DMA have also been positive, with average returns of 1.7% and median returns of 1.5%.  The three-month period has seen even better returns, with the S&P 500 averaging a 3.2% gain and a median return of 4.5%.

Digging a little deeper, Bespoke observes that in the last 30 years there have been 23 instances in which the S&P crossed its 50 DMA after at least three months of closes above it. In that three-decade span, the market has been up 65%, 74%, and 83% of the time over the following week, month and three months following such a 50 DMA breach.

Excluding the extreme outlier of 1987, the only three down periods over the following three-month period in the last 30 years have averaged a decline of just 0.8%. If historical patterns hold true to form, Bespoke analysts conclude, then Friday’s smackdown is not a good indicator that the next bear market is just around the corner.

As such, I’m primarily bullish in my holdings, and I’ve identified an options trade ready to return an easy 50%-plus in the short term.

Annaly Capital Management (NLY[1]) is a $10 billion mortgage REIT whose shares carry an annual yield of 11.4% at current levels. The mortgage REITs were annihilated over the past two years over the threat of rising interest rates, but now they are seen to be a highly-leveraged proxy on the improving mortgage market. NLY shares fell to their 450-week average at the end of 2013, which was the same level they hit at the end of the last major bear market. They doubled from there over the ensuing four years.

I recommend buying the NLY Feb. $10 calls at current levels (which are about 70 cents). My target for the calls is $1.10, but you should always be ready for a market turn, so place a stop at 55 cents, good till canceled.

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