Utility stocks have been rocking since the beginning of last year, rewarding anyone who made a contrarian investment in this usually conservative sector.
From the start of 2014 through Jan. 21, the Utilities SPDR (ETF) (NYSEARCA:XLU) has logged a gain of 34.2% — trouncing the 12.1% return of the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) in that same period. This year alone, XLU has delivered a return of 4.2%.
With these spectacular gains already in the rearview mirror, investors in utility stocks need to ask themselves what the source of additional gains will be.
Unfortunately, there appear to be more reasons to sell utility stocks than to buy.
Low Growth, High Valuations, Low Yields
By almost any measure, utility stocks don’t offer a compelling risk-reward profile for investors right now.
First, utilities are providing little in the way of growth. According to a recent Factset report, analysts are calling for earnings growth of 2.4% for utilities in 2015, behind the anticipated 6.3% growth of the broader S&P 500. The outlook isn’t much better for 2016: utility stocks are expected to generate earnings growth of 3.9%, below the 12.0% for the S&P and last among all sectors.
Valuation isn’t a reason to buy utilities, either. Factset reports that the utilities sector is trading at 17.8 times 12-month forward estimates, the third-most expensive sector behind only consumer staples and energy. At 17.8, the sector’s P/E is well above its own 10-year average of 14.4 as well as the 15.9 P/E for the S&P 500.
Separately, Standard & Poor’s calculates the price/earnings-to-growth (PEG) ratio at 3.7, tops among all sectors and far above the 1.5 PEG of the broader market.
It’s also tough to build a case for buying utility stocks on the basis of yield. At 3.1%, XLU’s yield isn’t too shabby with the 10-year Treasury near all-time lows, but it also isn’t offering much of an advantage over the 1.9% for SPY. Further, XLU’s yield has moved to all time low as shown in the accompanying images.
Utilities Are Now a Macro Play
Instead of trading on the basis of the more traditional measures outlined above, utility stocks have largely become a vehicle for betting on a continuation of the long-standing environment of rising stock prices, weaker natural gas prices, and falling bond yields.
The relationship to bonds is evident in the elevated correlation between XLU and long-term Treasuries, as represented by the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT). During 2014, the two funds had a correlation of 0.9 — the highest in any calendar year during the past decade.
Correlations can break down quickly, of course, but this helps illustrate just how much the sector’s performance depends on falling bond yields.
In the past year, of course, this has been nothing but a tailwind for utility stocks. However, the fact that valuations have become unmoored from historical levels means that the sector is dependent on three external trends for performance to continue at the current pace.
The broader equity market needs to keep rising, while natural gas prices and bond yields need to keep falling. If either of those pillars is knocked out of the equation, utilities are in jeopardy of underperformance or outright negative returns.
Add it up, and utilities are simply no longer the safe option they used to be. This is underscored by the chart below, which shows the average daily volatility of XLU since the start of 2014.
In recent months, the ETF has experienced much higher average daily swings than it did just a year ago. The increased in volatility was on full display Thursday morning, when the ETF whipped between $49.40 and $48.95 in the immediate aftermath of the European Central Bank’s quantitative easing announcement.
As a result, traders can consider buying puts on XLU here. This would have been unthinkable for most of the past decade, but now this trade can actually be a money-maker given the increased volatility.
Buying puts on a traditional widows-and-orphans sector is an unusual strategy, but this an unusual market — and traders need to adapt accordingly.
As of this writing, Daniel Putnam owned puts on XLU.
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