The Efficient Market Hypothesis argues that no investment strategy or signal can consistently outperform a simple buy-and-hold approach to broad stock averages over time. However, there is plenty of research that says otherwise, including my own 2014 Dow Award-winning paper “An Intermarket Approach to Beta Rotation.”
That paper highlighted just how important the utilities sector is, not just for tactical sector rotation, but also as a signal for the broader stock market changing volatility regimes.
When we look at utility stocks relative to the S&P 500, we can see the ratio is back to November 2021 levels. That was just around the time the large-cap bear market began. The relationship appears to be turning. Utilities stocks are starting to outperform just as we enter September, which is when I believe the risks are high for a credit event.
Why Utility Stocks Are Signaling a Crash
As I noted in the 2014 Dow award paper, “the Utilities sector has many unique characteristics relative to other sectors of the broader stock market, including its higher yield, lower beta, and relative insensitivity to cyclical behavior.” Historically speaking, the utilities sector has been instrumental in leading broad market averages. John Murphy, Edson Gould, Martin Pring, and many other well-known technicians often reference the utilities sector when identifying major market turning points.
There are leads and lags when it comes to identifying risk-on and risk-off periods.
For example, bonds are known to lead prior to equity market tops and bottoms. Utilities are the most bond-like sector of the stock market. Therefore, it is reasonable to argue that the sector also shows similar dynamics to bonds. I’ve proven this in the work behind that research paper.
It’s more than that though. Historically, utility companies were highly regulated, limiting their pricing power. This regulation made utilities more reliant on the cost of capital than revenue growth prospects.
The Bottom Line
The fact that utility stocks are so depressed relative to broad market averages this year makes them susceptible to a surprise run of outperformance. And such strength can serve as a warning sign of increased volatility and extreme market movement in the short term. If we look at utility sector outperformance historically, we see utilities tend to already be leading prior to major volatility spikes.
It’s interesting to me that utilities look to have bottomed relative to the S&P 500 right here just as news hits on multiple fronts of very real risks to the global economy.
Whether it’s Japan, China, leverage, or overall sentiment, the risk to me looks very real for September. Now keep in mind that this is not a suggestion to short. As I often say, “just because it’s raining doesn’t mean you’ll crash, and just because it’s sunny doesn’t mean you won’t.” Everything is ultimately about conditions that favor probabilities. It just seems that no one is really paying attention to the message of defensive outperformance, which may be exactly why now is the time to be defensive.
On the date of publication, Michael Gayed did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
