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The Most Direct Play on the Fed's Rate Cut

By Dr. Steve Sjuggerud
Thursday, September 20, 2007

Oh boy... It's finally arrived...

"Virtual bank" season is here again. I'm excited, as it takes years for it to come around. But it just arrived, thanks to the rate cut by the Federal Reserve.

The last time we entered virtual bank season, shares of Annaly (NLY) brought home a triple-digit total return. It looks like it could happen again.

In last month's issue of True Wealth, I called shares of Annaly a "strong buy." When I wrote that, the shares of Annaly closed at $14.03. Now, they're at $16.40. That's a 17% gain in a little more than a month. There's more upside to come in virtual banks...

Like traditional banks, Annaly borrows money at a low rate and reinvests it at a higher rate. That's all it does. But Annaly does a few key things that are completely different from traditional banks...

First of all, Annaly has no storefront. You can't walk in and get a loan from Annaly – there's nowhere to walk into. Second – and this is the important part – Annaly only buys in 100% government agency-guaranteed investments. So, Annaly has no credit risk – the government agencies are stuck with it...

Virtual banks like Annaly make money on the spread between short-term interest rates and mortgage rates. When they're investing risk-free and borrowing risk-free, they only make a small spread – say 0.5%, or 50 basis points. But they use something like 10 times leverage. That gives them total returns of up to 5%. And they distribute most of their returns as dividend payments.

While 5% doesn't sound exciting, the potential returns here can get silly, fast... For example, since the Federal Reserve cuts rates by half a percent, the spread for these companies widens to roughly 1%. Multiply that times 10, and they're paying 10% dividends. If banks are afraid to lend and mortgage rates rise by 0.5% as well, then they're paying 15% dividends.

And if the Fed cuts rates by 0.5% again, then they're paying 20% dividends. Once they're paying huge dividends, then everyone will want to own them, so the share prices could double.

My friend, with the first rate cut from the Federal Reserve, we're on our way.

It's virtual bank season again. If the Fed keeps cutting, then the returns these stocks can make will be comical, just like they were in 2000 to 2002.

When the cycle is right for virtual banks, you really want to own these things. And the cycle is right now... Get on board.

Good investing,


Market Notes


On January 3, 2001, Alan Greenspan surprised the market by cutting 50 basis points from the Fed's short-term interest rate...

Like today, stocks were close to all-time highs – the blue chips anyway – people were starting to worry about recession, and the Fed had held interest rates on a high plateau (6.5%) for the preceding seven months.

When the news hit the market, investors celebrated with a 300-point rally in the Dow.

Yesterday, Ben Bernanke surprised the market with his own 50-basis point rate cut, and investors celebrated with another 300-point rally in the Dow.

This could be the start of a new rate-cutting campaign from the Fed. But don't assume stocks have to rise if the Fed does keep cutting rates...

After his 50-basis point cut in January 2001, Greenspan continued cutting rates for the next two years, moving them from 6.5% to 1%...

Three days after Greenspan's surprise rate cut, the Dow was already trading below its pre-rate cut level... and 19 months later, the Dow had lost 30%...

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