One of the best trades of the decade will be upon us soon. In fact, now may be the time to start jumping in for a multi-year ride of over 2,000% in returns.
We’ve all looked back at pivotal moments on the markets and kicked ourselves for not jumping into a market that clearly had its back against the wall and had nowhere to go but up.
Remember crude oil in 1999 at $14 a barrel? Gold in 2001 at $250 an ounce? The S&P 500 at 676 in March of 2009? These were all bottoms at the end of deep retreats, with brief pauses before springing upward on fantastic climbs that saw the S&P surpass 2,090 (3.1-fold), gold surpass $1,900 (7.6-fold), and oil surpass $140 (10-fold).
Would you like to have another fantastic opportunity as that now? A market that has fallen pretty much all that it can and has nowhere to go but up? A market that, when it finally does start moving up, will continue to do so for years to come?
It isn’t oil or gold, both of which can still fall further from here. It isn’t the S&P either, which can have a correction at any moment. And even though the S&P does have fantastic upside potential for years to come, it most likely won’t give you more than about 10 to 20% upside per year at most.
No, I’m talking about an area that has fallen almost as much as it possibly can, and has upside potential surpassing 2,000% over the next few years, averaging some 200% to 400% per year for the next five years at least. But you are not going to like the sound of it, because it is awfully boring, and lacks any kind of sex appeal: mortgage lenders.
That case is pretty compelling. We know interest rates have descended as low as they possibly can, leaving the U.S. 10-Year Treasury’s yield with no more than about another half a percentage point that it can drop from here. This is definitely an industry at the end of its rope.
But not all interest rate plays will give you that 2,000% return over the next few years that I mentioned. There are some pretty specific stocks we need to turn to for a return like that.
Let’s first look at the picks that are easier to swallow before getting to my two controversial picks.
4 Mortgage Stocks With Potential
The industry we are looking at here is the Mortgage Investment industry, which includes mortgage lenders, Business Development Corporations which issue loans to companies, and holding companies which hold smaller banks and lending units.
Overlaying four of the largest U.S.-based companies in the space – Nationstar Mortgage Holdings Inc. (NYSE: NSM), Hilltop Holdings Inc. (NYSE: HTH), Ocwen Financial Corp. (NYSE: OCN), and Hercules Technology Growth Capital, Inc. (NYSE: HTGC) – onto a graph of the U.S. 10-Year Treasury yield, we find a very enticing pattern as graphed below. The companies’ stocks move almost in lock-step with Treasury yields.
During 2013, as the bond market was anticipating the beginning of reductions to the Federal Reserve’s monthly bond purchasing program known as Quantitative Easing 3 (QE3), Treasury prices gradually fell and their yields gradually rose (in black below). As yields rose, our four stocks rose with them (in green).
Then, in 2014, despite the reduction of the Fed’s bond buying program being well underway, Treasury prices rose and their yields fell. Once again, our four stocks moved in lock-step with Treasury yields, rolling with them downhill (in red).
Source: BigCharts.com
It may have surprised many to have seen Treasury prices rising and yields falling in 2014 while the Federal Reserve was reducing stimulus. But we must remember that other things were happening in other parts of the world that made U.S. Treasuries very appealing.
For instance, Japan increased its stimulus measures, China introduced a little aid of its own, while Europe commenced a light corporate bond buying program with plenty of talk of full blown stimulus just around the corner. This drove foreign bond yields down dramatically, with 10-Year bond yields in Italy, Spain and the U.K. dropping below 2%, and yields in Germany and Japan falling below half a percent.
With the U.S. 10-Year yield still at 3% at the beginning of 2014, a great quantity of foreign capital was redirected to America to take advantage of some of the best rates in the developed world. Hence, bond prices rose and yields fell in the U.S. all throughout 2014 due to all this foreign inflow despite continuing reductions to the Fed’s bond buying program.
Yet now that the U.S. 10-Year yield is below 2%, it really does not have very much room to fall much further. And with the Federal Reserve expected to begin raising interest rates possibly in late 2015 or early 2016, Treasury yields don’t have very much time to fall much further.
The 10-Year yield could still drop to 1%, but that is just a drop in the bucket over the longer course of time. At some point within the next year or so, rates will begin to rise. And when they do, they will continue rising for years to come until “rate normalization” at the 5 or 6% level in about 5 years’ time or so.
As we can clearly see in the graph above, our four candidate stocks look poised to deliver some fantastic upside potential as they rise with yields. Here’s a brief look at each company’s activities:
• Nationstar Mortgage Holdings Inc. (NYSE: NSM), with a market cap of $2.35 billion, headquartered in Lewisville, Texas, provides residential mortgage loan services, which include the origination, packaging, and sale of government-sponsored enterprises mortgage loans into the secondary markets. It also provides refinancing services to its existing customers helping them to lower their monthly payments.
• Hilltop Holdings Inc. (NYSE: HTH), with a market cap of $1.63 billion, headquartered in Dallas, Texas, operates as the holding company for PlainsCapital Bank that provides business and consumer banking services including lines of credit, equipment loans and leases, letters of credit, agricultural loans, commercial real estate loans, and other loan products, in addition to term financing on commercial real estate properties, construction financing, residential mortgage loans, Internet banking services, business check cards, and treasury management services.
• Ocwen Financial Corp. (NYSE: OCN), with a market cap of $1.53 billion, headquartered in Atlanta, Georgia, services and originates mortgage loans for residential and commercial properties, as well as asset management services to owners of mortgage loans and foreclosed real estate. It offers conventional, government insured, and non-agency credit such as subprime loans.
• Hercules Technology Growth Capital, Inc. (NYSE: HTGC), with a market cap of $943 million, headquartered in Palo Alto, California, is a Business Development Company providing venture debt, senior secured loans, and growth capital to privately held venture capital-backed companies in all stages of development from lower middle market companies to publicly listed corporations. The firm provides capital financing for capital extension, management buy-out and corporate spin-offs, intellectual property acquisition, mezzanine loans, domestic and international expansion, marketing development, and manufacturing expansion.
Yet as strong as these companies may prove to be in following bond yields up, there are two other stocks that could be packing the most explosive upside potential of all – companies which most people wouldn’t consider touching even if they were for free (which they almost are): Fannie Mae and Freddie Mac.
2,000% Upside in Just One Year
Mention Fannie and Freddie to an investor who survived the last stock market implosion from 2007-09 and he will likely tell you to go fly a kite.
The Federal National Mortgage Association (OTC: FNMA) [aka Fannie Mae] and the Federal Home Loan Mortgage Corporation (OTC: FMCC) [aka Freddie Mac] are “government-sponsored enterprises” (GSEs) that purchase mortgages which banks and other lenders have issued to homebuyers and businesses. Fannie and Freddie then package these mortgages together into funds or stocks, known as “mortgage-backed-securities”, which they sell to investors.
The activity is crucial to the housing market and banking sector alike. First, it allows a bank or Savings & Loan to sell its mortgages to Fannie and Freddie right away, receiving their capital back plus a small profit immediately, instead of having to hold the mortgages on their books for 30 years. The lenders are now free to reuse that capital to issue new mortgages, which keeps the wheels of the housing market turning.
Second, it allows mortgage risk to be passed off to Fannie and Freddie, relieving banks and other lenders of the risks associated with defaulting mortgages.
The only problem, however, is that when there is a housing crisis, Fannie and Freddie are stuck holding the bag – with a great big gaping hole at the bottom of it. This is why their stocks plummeted from 2007-08, losing more than 95% of their value, as graphed below.
Source: BigCharts.com
But notice how their stocks performed in 2013 when Treasuries fell and yields rose, as graphed below. From early 2013 until March of 2014, both stocks (yellow and gray) rose nearly 2,000% in less than one year.
Source: BigCharts.com
Of course, their stocks readily retreated during 2014 as Treasury prices rose and yields fell. But again we come to that all important outlook for rising interest rates for years to come. Fannie and Freddie have already proven how well correlated they are to yields. With yields pretty much as low as they can possibly be to within about half a percentage point, these truly are stocks at rock bottom with very little downside and a tremendous amount of upside. What is more, at just a little more than $2 a share, the price for this ticket to ride is extremely small.
If you have been wishing for another once-in-a-decade opportunity to hit a market at its bottom and ride it all the way to its next top, the Mortgage Investment industry is one of your best candidates, with Fannie Mae and Freddie Mac being your maid and butler that will escort you all the way to the vault.
Joseph Cafariello
