The stock market didn’t exactly react well to the Fed’s non-decision to keep the targeted Fed funds rate unchanged last week. The S&P 500 and Dow Industrials both spent most of Thursday and Friday in freefall, and as I’m writing this on Monday, both are only modestly in the black.
But one corner of the market has held up a lot better than the rest: Boring, “bond-like” REITs. You see, while stock prices dropped like a rock, bond prices actually enjoyed a nice rally. And REITs, which have come to be seen as bond replacements in this era of ultra-low bond yields, have followed suit.
I’m not wildly enthusiastic about the prospects for the broader stock market over the remainder of 2015. But I do think that REITs offer a pocket of value. I don’t see bond yields rising much in today’s market. If the Fed is too scared to raise rates, that tells you that there are enough macro risks out there to keep bond yields low. But if and when the Fed finally does get motivated to raise rates, I don’t see that translating to higher long-term bond yields, or at least not for a while. A higher Fed funds rate is disinflationary, which is good for bond prices.
So for the time being, we seem to be in a sweet spot for bonds where, irrespective of what the Fed does, bond yields should stay low for a while. And as long as bond yields stay low, REITs should continue to outperform the broader market.
But there is one more reason to believe that REITs are due to continue their rally. Several of the names I follow—such as Realty Income Corporation (NYSE:O), National Retail Properties (NYSE:NNN), Spirit Realty Capital Inc (NYSE:SRC), Stag Industrial Inc (NYSE:STAG), VEREIT Inc (NYSE:VER) and Digital Realty Trust Inc (NYSE:DLR)—are very heavily shorted right now. Short sellers have been punishing the sector for months in the view that higher interest rates would wreck the sector.
But here’s the thing about heavily-shorted stocks. When you short a stock, you are obligated to buy it back. So when you see a heavily-shorted stock, you know that there is a lot of buying that must happen… eventually. And if too many short sellers try to close their positions at the same time, you get a short squeeze that can send the stock price sharply higher. To toss out a few examples from the list above, Realty Income has a short interest currently equal to more than 10 days’ worth of daily volume. VEREIT has a short ratio of 8 days to cover. And Digital Realty has an almost ridiculously high short ratio of 18 days to cover.
Short sellers have had a great six months shorting the REIT sector. It’s been a profitable trade for them. But with REITs showing strength right now, I expect those short sellers to start bailing… and soon.
Even though they generally have a low correlation to the broader market, REITs are still stocks. And if we have another volatile rough patch like August, you can expect them to fall alongside the rest of the market, at least temporarily. But I still expect REITs to massively outperform the broader market for the remainder of 2015, particularly if the shorts get squeezed.