Stocks might be overdue for a pullback, but at least one sector looks poised to keep generating heat.
An improving U.S. economy and the coldest March in recent memory have the utility sector putting up electrifying returns so far this year.
Usually, that would make these stocks a prime source of funds in any generalized selloff, but given their defensive characteristics and high dividends, utilities should maintain their relative outperformance if and when stocks cool off.
After all, cracks are starting to appear in the rally. Small-cap stocks — a pretty good proxy for risk appetite — have run out of steam, as we noted recently.
More worrisome, the Dow Jones Transportation Average has lost its bid. As spooky as the divergence between small caps and large caps may be, the action in the Dow Transports is what really sets traders on edge.
Not only are the Transports seen as a bellwether for the broader economy, but they’re at the center of Dow Theory, a widely followed form of technical analysis. One of the tenets of the theory is that the market can only make new highs when both the Dow Transports and Dow Jones Industrial Average move in concert. Recent weakness in the Transports is not a good sign.
Meanwhile, the Dow Jones Utility Average is outperforming the broader market, and has held its own as investors scurried out of riskier small-cap stocks and the S&P 500 stumbled.
Have a look at this one-month chart, courtesy of S&P Capital IQ, showing the relative performance of the Dow Utilities, the S&P 500 and the small-cap benchmark Russell 2000:
If investors are indeed rotating out of small caps and into large caps for their more defensive attributes, then that should only benefit utilities all the more. It’s about as defensive a sector as you can get.
Not only are their sales and profits generated here in the U.S. — a relative bright spot in the global economy — but, at 4%, utilities boast the highest average dividend yield of any sector in the market.
At the same time, the sector has been crushing it on a price basis, too. Utilities are the third best-performing sector of the S&P 500 so far in 2013, with a 12% gain. That beats the broader market by 3 percentage points. Add in the dividends, and the outperformance widens further.
As good a year as it’s been for utilities, unlike the Dow or S&P 500, the Dow Jones Utility Average is still about 8% below its all-time closing high. With Dow Utility components like Dominion Resources (NYSE:D), PG&E (NYSE:PCG) and NiSource (NYSE:NI) at or near 52-week highs, it might not be too long before the average takes out that level.
Further out, both the economic backdrop and the Fed’s policy of crushing interest rates remain supportive of utilities. Housing is on the mend, for one thing. And low rates not only make the sector’s dividends extremely compelling to income investors, but also help juice industry profits.
As Morningstar analyst Travis Miller writes:
“The supposed headwinds on the horizon for regulated utilities continue be a mirage. Low interest rates keep feeding earnings growth as utilities refinance their large balance sheets. Energy demand remains steady as housing demand rebounds, regional economies stabilize and low energy prices thwart energy efficiency efforts.”
If the market does retreat, utilities will of course take a step back too. But it should be a shallower selloff, thanks to their defensive aspects and the hefty dividends providing a downside cushion.
Beyond that, the fundamentals support outsized returns for the utilities sector through year-end and beyond.
As of this writing, Dan Burrows did not hold a position in any of the aforementioned securities.