It Might Be Time to Flip the Switch on Utilities

by Daniel Putnam | December 2, 2011 6:00 am

Utilities have performed exceptionally well in 2011, but the sector is in jeopardy of becoming dead money in the year ahead.

Utility Stocks
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Through Thursday, the Select Sector SPDR-Utilities ETF (NYSE:XLU[1]) had delivered a year-to-date return of 15.76%, versus 0.84% for the SPDR S&P 500 ETF (NYSE:SPY[2]). The reasons for this substantial outperformance should be familiar: In a high-risk, low-yield environment, investors have gravitated to safer, high-dividend areas of the market. At this point, however, betting on an extended continuation of utilities’ performance advantage is likely to prove unrewarding. Absent the support of the low-risk/high-dividend trade, the sector doesn’t have much to offer.

First, the fundamental outlook for utilities isn’t particularly compelling. Standard & Poor’s estimates that utilities’ earnings will finish 2011 in negative territory and fall another 1.5% in 2012, the only one of the 10 major sectors projected to operate in the red in the coming year. S&P also expects negative earnings in each of the next four calendar quarters. Increased regulatory activity and a slowdown in domestic infrastructure investment also represent near-term hurdles for the industry.

Second, consider that the sector is no longer attractively valued following its outperformance thus far in 2011. According to AltaVista Research, the XLU components are trading at the highest collective forward P/E ratio since 2008, yet returns on equity are at their lowest level in the same interval. Standard & Poor’s calculates a forward P/E of 13.5 for the sector, a full 25% above the 10.8 P/E for the S&P 500 Index. The PEG ratio, meanwhile, checks in at 2.8 versus 1.0 for the broader market. These metrics aren’t limited to large-caps; utility stocks also carry a premium within both the S&P MidCap 400 and the S&P SmallCap 600 indices.

Third, while the sector continues to offer very attractive yields relative to the broader market, the gap no longer is as large as it once was. The XLU currently is yielding 3.9%, versus 2% for SPY. While it’s true that this advantage is sizable, particularly at a time of low bond yields, it also represents a meaningful 17% decline from the 2.3 percentage point spread that separated the yields of the two ETFs at the start of the year.

Also, consider that at the current year-to-date performance gap of about 15 percentage points over SPY, 2011 is on track to bring the second-largest outperformance for XLU in the 13-year history of the ETF. The highest margin occurred in 2000, and this was followed by three consecutive years of underperformance for utilities relative to the broader market.

All of these factors need to be considered within the context of the impact that the “risk-off” market has had on the utilities. The flip side of this trend is that any sustained revival of investors’ animal spirits is very likely to be accompanied by underperformance for utility stocks. The search for relative safety, while one of the most important drivers of sector performance during 2011, also has become a crowded trade at this stage. Wednesday’s market action might provide a hint of what the future holds: While XLU surged 2.8% in the rising market, it finished well behind the 4.1% gain of the S&P 500.

The bottom line: Utilities can remain a safe haven as long as the market’s primary emphasis is on avoiding risk, and there are plenty of individual companies[3] that can provide investors with solid returns over time. Once the safety trade begins to reverse, however, utilities will lose their most important pillar of support. It might be time for investors to consider looking for yield elsewhere.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned stocks.

  1. XLU:
  2. SPY:
  3. individual companies:

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