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The Preferred Defensive Sector – Utilities, Not Consumer Staples

Look for the XLU to continue its hot run through 2014


With the first half of 2014 in the books, investors are focusing on sectors that will continue to generate robust gains while also earning income if the broader market begins to trade sideways.

Many are focusing on defensive sectors, which tend to outperform during choppy or adverse market conditions. That’s the right move, but the question for investors during the second half of 2014 is which defensive sector is likely to outperform.

First Half of 2014

During the first half of 2014, utilities were the best-performing S&P 500 sector, notching a return of 6.1%. Six of the nine sectors reported positive returns, while consumer staples declined 2.29%, and was the second biggest laggard, outpacing cyclical stocks by 2.5 percentage points.

utilities consumer staples sector performance

Given that first-half performance, investors might be tempted to jump into consumer staples in the hope that they’ll play catch-up for the rest of 2014. However, with interest rates likely pegged at historically low levels and natural gas prices still at comfortable levels, utilities could continue to outperform.

Consumer Staples – Outperforming for the Past Decade

In recent years, though, consumer staples have the lead.

utilities consumer staples xlu xlp
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During the past 10 years, consumer staples have outperformed utilities; the ratio between the Utilities SPDR (XLU) and the Consumer Staples SPDR (XLP) has declined from a peak of 1.46 in 2008 to a trough of 0.86 in late 2013.

The decline in the ratio of nearly 34% to current levels near 0.97 is a reflection of slow economic growth that followed the great recession, which began at the end of 2008. The low level of the spread shows investors that consumer staples are actually rich in value relative to utilities based on the past 10 years of performance.

The spread seems to have formed a bottom, however, and an uptick in growth could lead to a strong rebound in factory activity, which could benefit the utilities space.

Input Costs Remain Subdued

natural gas prices
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Also helping utilities outperform in the first half of 2014 were low natural gas prices. Natural gas (along with coal) is the fuel of choice to drive turbines, which generate electricity. While nat-gas prices have increased by about 8% this year, they continue to trade below the 20-year average of $4.90 per MMBtu (millions of British thermal units).

Production continues to grow thanks to horizontal drilling and hydrofracking. Meanwhile, development of shale natural gas resources continues to spur growth in natural gas production, with producers seeing higher prices as a result of growing demand — especially from electricity generation sectors.

The Department of Energy estimates that natural gas production will grow by an average rate of 1.6% per year from 2012 to 2040, more than double the 0.8% annual growth rate of total U.S. consumption over the period. This compares to an average increase in consumption of 0.9%/year.

Low Rates Keep Utilities Attractive

Interest rates in the U.S. have remained at historic lows, too as economic growth has increased at a modest pace — good news for any stocks that get by on yield.

The 10-year U.S. government yield is at 2.64%, 43 basis points lower than the closing yield of the 10-year on Dec. 31, 2013. The first half’s decline in Treasury yields has been met with increased demand in high-yielding dividend stocks such as utilities.

Although June’s economic data has seen improvement, it has not been strong enough to push interest rates substantially higher. The 10-year yield is trading below its 200-day moving average near 2.74%, and with the Fed likely to keep fund rates on hold through the first half of 2015, utilities should continue to generate solid returns.

Consumer staples, on the other hand, will likely only experience strong returns if the U.S. economy dips into a recession.

The trade: Investors looking to gain exposure to utilities can purchase the XLU ETF near the 20-day moving average at $43 per share.

As of this writing, David Becker did not hold a position in any of the aforementioned securities.

Article printed from InvestorPlace Media,

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