Who said utilities are boring?
Although still thought of as the preferred investment for widows and orphans, utilities have been a source of outstanding total returns thus far in 2013. Since the beginning of the year, the Utilities SPDR (NYSE:XLU) has surged 15.7%, outpacing the 11.9% return of the SPDR S&P 500 ETF (NYSE:SPY). This is an unusually wide margin of outperformance for a sector that typically lags in rising markets.
Notable winners in the group include Dynegy (NYSE:DYN), ahead 27.8% year-to-date; Exelon (NYSE:EXC), ahead 23.5%; and NRG Energy (NYSE:NRG), up 18.8%. Utilities are the market’s third-best sector year-to-date, behind only the similarly defensive healthcare and consumer staples sectors.
The fact the rally in utilities has been accompanied by significant outperformance for other defensive groups is the tip-off that this move is more about general market trends than news-specific to utilities. In fact, just about any stock or sector that lacks direct exposure to the weak global economy has been exceedingly popular with investors in 2013.
At this point, however, it’s necessary to question how much, if any, of the rally in utilities has to do with sector fundamentals.
According to Standard & Poor’s, the utilities sector is on track for earnings regression of 3.3% in 2012, versus growth of 4.5% for the S&P 500. Next year’s estimate is for growth of 0.6%, compared to 7.4% for the broader market. Despite this, utilities are trading at 16.2 times earnings, a premium to the 14 P/E of the S&P 500. Standard & Poor’s calculates utilities’ price/earnings-to-growth ratio at 3.9, triple the 1.3 PEG for the index.
Here, the skeptical reader will say “But utilities are about yield, not growth!” True enough, but utilities fall short on this count as well. XLU currently offers a yield of 3.57%, down about a half-point from where it started the year and well below its historical average.
As a result, utilities are no longer offering an attractive alternative to bonds. On Thursday morning, for instance, XLU’s yield stood only about 60 basis points above the 30-year Treasury and below that of both iShares JPMorgan USD Emerging Markets Bond Fund (NYSE:EMB), at 3.73%, and iShares High Yield Corporate Bond Fund (NYSE:HYG), at 4.87%.
While a 3.57% yield is still nothing to sneeze at these days, the key consideration here is that a yield-producing investment, utilities have lost a great deal of their relative appeal after the rally of the past four months.
Investors also should consider the relationship between utilities and interest rates. While utilities powered through the December-February uptick in Treasury yields with no ill effect, the sector tends to have a strong negative correlation with Treasury yields on a longer-term basis — especially in the past three years, as shown in the chart below. As a result, investors in utilities stocks might be in for some pain once rates finally embark on their much-anticipated long-term uptrend.
Put it all together, and utilities are no longer looking like the “safe” way to play the stock market. Anyone putting new cash into the sector right now is essentially making a bet that the substantial outperformance of defensive stocks will continue. But with the defensive groups already having come so far in recent months, the risk/reward profile of this trade is no longer as attractive as it was just to or three months ago.
As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.