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The Best Utility Buys in the Late Stage Bull Market

By Roger S. Conrad, on Mar. 2, 2015

For most of January, utility stocks continued their market-leading performance of 2014. However, the Dow Jones Utilities Average has given up almost 10 percent of its value in subsequent weeks, reflecting a shift in momentum and a welcome break after last year’s breathless rally.

Financially and operationally, utilities are at their strongest since the early 1960s. Relations with regulators remain salutary in most states. And utilities have systematically cut debt and eliminated near-term refinancing risks, while shedding operations outside their core regulated businesses. Meanwhile, solar power has emerged as a powerful new engine for future earnings growth.

Technical factors also favor utility stocks. Since 1984, the Dow Jones Utilities Average has recorded a positive return in January 16 times; on 15 of these occasions, the index finished the year in the green. A 3.3 percent return in January 2015 suggests that the Dow Jones Utilities Average could enjoy another solid year.

(Click graph to enlarge.)
January Effect Bar gRaph

The lone exception to the January Effect occurred in 1987, when rising inflation and tight monetary policy eventually triggered one of the worst one-day crashes in history.

But in early 2015, global deflation is the clear and present danger, the US dollar is king, and major commodities such as crude oil and iron ore have pulled back significantly from year-ago levels.

Conventional wisdom calls for the Federal Reserve to raise interest rates this year. However, hiking rates when the European Central Bank and other monetary authorities have turned to quantitative easing could propel the US dollar’s value to levels that cripple exports and multinationals’ profits. Such a move risks a severe dislocation to the financial system.

Interest Rates and Utility Stocks

The dominant narrative still blames utility stocks’ poor performance in 1987 on rising interest rates. After rallying 9.1 percent in January 1987, the Dow Jones Utilities Average plunged by almost 30 percent, before finding a bottom on Black Monday, Oct. 19.

But by year-end, the Dow Jones Utilities Average had narrowed this loss to less than 8 percent. Although utility stocks underperformed the S&P 500 by almost 15 percentage points that year, the damage was far less than the pullbacks that happened in 2001, 2002 and 2008.

Get ready for an even bigger surprise: The Dow Jones Utilities Average’s ups and downs in 1987 correlated more closely with movements in the S&P 500 than in almost any other year since 1984.

Check out our table comparing the r-squared between the Dow Jones Utilities Average and the S&P 500 and the yield on 10-year treasury notes over various periods. R-squared values closer to 1 indicate higher levels of correlation.

Utility Stocks and Interest Rates

Pick any time interval you want—the Dow Jones Utilities Average’s annual returns correlate far better with the stock market than interest rates.

Although utility stocks and other dividend-paying equities offer upside exposure to growth in their underlying businesses, investors continue to treat these securities as though they are bonds that pay a fixed coupon.

Best-Picks

Higher interest rates can adversely affect a business if they’re not accompanied by increased returns on investment. But there’s no lock-step relationship between utility stocks and interest rates—or most groups of dividend-paying equities, for that matter.

Nor are rate swings likely to do any damage to earnings this year: Despite the volatility in the 10-year Treasury yield, utilities’ corporate borrowing rates remain near all-time lows.

Follow the Oil

What’s driven the recent pullback in utility stocks? Oil prices are partially to blame.

With the exception of wholesale power producers—whose returns are affected by volatility in natural-gas prices—utilities’ profits have scant exposure to energy prices because any increases automatically pass through to customers.

This resilience explains some of the utility sector’s momentum in the fourth quarter of 2014 and January 2015: Falling oil and gas prices triggered an exodus of capital from energy stocks to this perceived safe haven.

When oil prices began to stabilize, some of this fast money rotated out of utility stocks and into energy equities.

The growing popularity of exchange-traded funds (ETF) has magnified the price fluctuations associated with short-term sector rotation, especially on equities with the heaviest weightings in these portfolios.

Duke Energy Corp (NYSE: DUK), for example, wears the crown as the top position in three ETFs offering one-stop exposure to the utility sector: Utilities Select Sector SPDR (NYSE: XLU), iShares US Utilities (NYSE: IDU) and Vanguard Utilities (NYSE: VPU).

Since Jan. 28, 2015, the stock has given up almost 10 percent of its value, compared to the 7 percent losses posted by the three ETFs.

The proliferation of exchange-traded funds makes it easier for investors to slosh money around between sectors as part of a short-term strategy. And every sale or purchase of these vehicles acts as a program trade, affecting the heavily weighted stocks the most.

How long will the market buy energy stocks and sell utilities? The consensus view calls for oil prices to follow a V-shaped recovery similar to what happened when commodity prices collapsed in late 2008 and early 2009.

However, as my colleague Elliott Gue has warned Energy & Income Advisor subscribers, odds favor a U-shaped recovery like the one that took place in mid-1980s, when OPEC ramped up output to regain market share. This extended pain trade forced oil and gas producers to rebalance the market by cutting capital expenditures. Low oil prices also helped to spur demand.

Producers have slashed their spending plans for 2015 and reduced their rig counts. However, Apache Corp (NYSE: APA) is one of the few US producers to announce reduced expenditures and lower production; most independents appear to be banking on a price recovery at someone else’s expense. Meanwhile, US inventories have swelled to record levels.

If oil prices experience a U-shaped recovery, expect energy equities and utility stocks to switch places once again.

Strategy

In this late-stage bull market, investors should continue to pursue the strategy we’ve outlined in recent issues.

First, don’t pay more than our target entry prices for any stock. And if you do wade into the energy sector, stick to the strongest companies—chiefly, the ones in our Conservative Income Portfolio and on our Top 10 Drips List.

Second, keep a look out for stocks whose upside momentum has propelled them to frothy valuations where it makes more sense to take some profits off the table.

As always, we remain focused on owning the best names at the lowest possible prices—a sure-fire way to accumulate dividends and build sustainable wealth. However, taking advantage of the opportunities created by upside and downside momentum also makes sense in an aging bull market.

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