Don’t Expect Utilities to Stay Defensive During a Downturn

Over the years, investors have come to expect certain performance characteristics from utilities, including reliable dividends, low volatility and outperformance in tough markets. However, the sector’s performance so far in May raises some red flags as to whether it can truly be considered defensive at this juncture.

Last week — from Friday, May 17 through Friday, May 24 — the S&P 500 finally exhibited some weakness with a moderate decline of 1%, as gauged by the SPDR S&P 500 ETF (SPY).

During that same time period, the Utilities SPDR (XLU) slid 3.7%. Plus, it’s been lagging the broader market by a wide margin. Month-to-date, XLU is off 6.3%, nearly nine points behind the 3.5% gain of SPDR. All of the other SPDR sector ETFs are in positive territory for the month.

What’s going on here? Well, more than anything, the shortfall in utilities is a reflection of the current make-up of the sector’s shareholder base rather than its fundamentals or even the recent uptick in interest rates. The utilities sector is the poster child for the year-to-date surge in “bond proxy” stocks. With little in the way of yield available in bonds, many investors have dipped a toe into the stock market through relatively stable, high-dividend payers — a trend that has also been reflected in the outperformance of consumer staples and healthcare stocks.

This has certainly worked in favor of utilities –– and low-volatility ETFs such as the PowerShares S&P 500 Low Volatility Portfolio (SPLV). At the same time, though, it also puts the sector in a position where it may begin to deliver performance characteristics that are inconsistent with historical patterns.

Namely, investors may not enjoy its typical strength in down markets.

To start, those who have favored bond proxies may not necessarily have the steady hand to weather an expected downturn in their “safe” income investments. Just since the beginning of May, for example, XLU has experienced nearly $300 million in redemptions. The process of shaking out the weak hands may have further to run if broader market performance remains unsteady.

On top of that, the inflow of cash from those in search of low-risk income — and the accompanying 24% rally in utilities from mid-November through the end of April — has distorted valuations in the sector. The S&P reported that as of May 16, the utilities sector had a price-to-earnings ratio of 16.5 on 2013 estimates, compared with 15.1 for the S&P 500.

This premium is in place even though utilities is the only sector expected to deliver negative earnings-per-share growth this year, -0.3% versus growth of 6.8% for the S&P 500. The result of this disparity, reports S&P, is that the P/E-to-growth (PEG) ratio for utilities is a whopping 4 — the highest of all sectors and well above the 1.4 of the broader market.

The utilities ETF still offers an attractive absolute yield of 3.64%, but this is close to the all-time low established in late 2007, and it is on the low end of the historical range in terms of its premium of over the S&P (currently at about 180 basis points).

In short, utilities were ripe for a correction. This may attract new buying interest from investors who have been conditioned to buy the dips in defensive stocks during the past few years, but be careful not to take a rally as an “all-clear” signal.

The growing presence of risk-averse investors in utilities may cause the sector to perform in unexpected ways in the weeks and months ahead. The shortfall in XLU amid the market weakness of the past week is a warning sign, and investors should take heed.

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

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