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Market Currents: Key Trends to Drive Returns in 2015

By Roger S. Conrad, on Jan. 21, 2015

The Dow Jones Utilities Average returned 30.7 percent in 2014, its fattest gain since 2000. The S&P 500 Telecommunication Services Index, however, generated a total return of only 3 percent.

And after a torrid start to the year, the plummeting price of crude oil and natural gas liquids (NGL) took the starch out of the Alerian MLP Index, which closed the year with a 4.8 percent gain.

Thus far in 2015, the Alerian MLP Index has sunk another 3.6 percent, while the Dow Jones Utilities Average has climbed by 1.4 percent.

Shares of regulated utilities have started the year strong for the same reasons they finished 2014 with their best fourth-quarter return since 2014: Income-seeking investors continue to rotate into the sector to limit their exposure to falling oil prices.

This perceived safety seemingly outweighs the Dow Jones Utilities Average’s paltry 3.1 percent yield. By comparison, the Alerian MLP Index offers a current return of 6.1 percent and the S&P 500 Telecommunication Services Index yields 5 percent.

Despite the growing popularity of exchange-traded funds (ETF), sector rotation will only take you so far.

Consider that the six master limited partnerships (MLP) in our model Portfolios last year generated an average total return of 26.2 percent, easily trouncing the 4.8 percent return posted by the Alerian MLP Index and popular ETFs that track this index.

Bottom Line: Buying individual stocks selectively improves your chances of outperforming, especially in a late-stage bull market where the number of stocks leading the rally continues to narrow.

Exchange-Traded Fun

The ETF world does include innovative offerings that individual investors can use to pursue strategies that traditionally have been the province of professionals.

Last fall, for example, we booked a 15.3 percent gain over four weeks in ProShares Ultra Utilities (NYSE: UPW) as part of a short-term trade to capitalize on seasonal strength for utility stocks. This specialty ETF gave moves two percentage points for every single-point move in the Dow Jones Utilities Average.

And Conservative Income Portfolio holding iShares Utilities Bond (NYSE: AMPS) provides easy exposure to a diversified portfolio of mostly near- to intermediate-term bonds issued by essential-services companies—an asset class that’s difficult for individual investors to access.

However, the diversified exposure to a specific sector, industry or theme that’s such a selling point for ETFs effectively locks in underperformance because their underlying portfolios usually include the best and worst stocks that fall into that category.

Picking a sector-focused or thematic ETF may be easy, but selecting individual stocks can be more rewarding—with some homework and luck.

But investors shouldn’t stick their heads in the sand and ignore the rise of ETFs; the popularity of these investment vehicles helps to exaggerate price swings to the upside and downside.

“How They Weight” lists the 10 largest holdings in Utilities Select Sector SPDR (NYSE: XLU), which boasts a market capitalization of $7.73 billion.

Two other prominent utility-focused ETFs, iShares Utilities (NYSE: IDU) and Vanguard Utilities (NYSE: VPU), allocate their capital to the same top 10 holdings.

How They Weight

Utilities Select Sector SPDR’s three largest positions—Duke Energy Corp (NYSE: DUK), NextEra Energy (NYSE: NEE) and Southern Company (NYSE: SO)—together account for almost 25 percent of its underlying portfolio.

These heavily weighed stocks closely follow the ETF’s fortunes, exhibiting a high R-squared correlation coefficient relative to the fund. Total returns over the past 12 months and betas (a measure of volatility) are also almost 1-to-1 with Utilities Select Sector SPDR.

These statistics raise an important question: Do price movements in these individual stocks call the tune for the ETF, or does is the fund the maestro?

Over the past 30 days, an average of 14.2 million shares of Utilities Select Sector SPDR traded hands daily—a volume that easily eclipses Duke Energy’s average of 3.3 million shares, Southern Company’s 5 million shares and NextEra Energy’s 2.1 million shares.

The relatively low trading volumes for these three stocks reflect the buy-and-hold approach that most individual and institutional investors take in the utility sector.

But ETF-related buying and selling effectively increases the volatility in these heavily weighted names, despite their large market capitalizations and relatively stable shareholder bases.

Although the momentum has worked in these stocks’ favor over the past year, this trend could easily reverse when sector-switching ETF traders shift their money elsewhere.

These dynamics create a situation where unwary investors can mistake ETF-driven volatility for a more meaningful re-rating and get whipsawed when they sell their positions.

But the rise of ETFs also creates opportunities for individual investors. Because the popularity of these fund products can exaggerate movements to the upside and downside, stocks caught up in this momentum can reach unsustainably high or low valuations.

Savvy investors have an opportunity to sell the upside and buy the downside. This approach requires a difficult psychological adjustment for those accustomed to buying and holding, but it can offer opportunities to lock in sizable gains.

Last month, for example, we sold Conservative Income Portfolio holding SCANA Corp (NYSE: SCG) for a 33 percent gain, locking in the equivalent of 19 quarters’ worth of dividend payments. Investors can redeploy the proceeds to names that trade at attractive valuations, offer higher yields and have less near-term downside risk.

This issue’s Portfolio article weighs the merits of this strategy and highlights several potential candidates for this strategy and prices at which we would consider taking profits.

With the Dow Jones Utilities Average not far removed from an all-time high after posting its biggest annual gain since 2000, only one of Utilities Select Sector SPDR’s top 10 holdings trades under our buy target: Aggressive Income Portfolio holding Exelon Corp (NYSE: EXC).

This utility offers exposure to several near-term upside catalysts, including the acquisition of Pepco Holdings (NYSE: POM), a transaction that should enable the company to resume regular dividend growth.

Other positives include reduced generation capacity in key markets after the shutdown of older coal-fired capacity and a deal with regulators in several states that would keep Exelon’s nuclear reactors running by improving their competitiveness with gas-fired facilities.

Special situations of this nature represent the best places for new money in a year when the utility sector trades at frothy valuations.

Interested in learning more about Conrad’s Utility Investor? See what Roger Conrad has to say about how to protect your portfolio in an aging Bull Market.

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