Having covered utilities and other essential-service stocks for almost 30 years, I’ve managed my personal account and model Portfolios through more than a few economic cycles and bull and bear markets.
One lesson I’ve gleaned from this experience: You can enhance your overall returns by taking some profits off the table when other investors throw valuation metrics out the window and buy hand over fist.
Price-to-earnings ratios, price-to-book ratios and dividend yields will never pinpoint exact turning points in individual equities, a specific sector or the broader market. Stocks can rally much higher or sink much lower than you expect. Equities can also stay at these ostensibly extreme valuations for so long that you’ll question whether these metrics matter anymore.
At the same time, valuations also help us to identify when investors’ expectations have fallen so far that companies can’t help but surprise to the upside and when sentiment has reached levels that increase the risk of disappointment.
In the late 1990s, valuation fell out of style. Instead, investors focused on momentum, inventing complex systems based on technical analysis to identify potential inflection points in a stock.
By focusing on charts instead of fundamentals, the consensus failed to notice when valuations had reached absurd levels. These high flyers crashed to earth during the relatively mild 2000-02 recession.
Today, the proliferation of exchange-traded funds (ETF) and other passive strategies has produced similar dislocations, with money sloshing into a sector or theme with little regard to underlying fundamentals.
Late last year and in early 2016, investors in master limited partnerships (MLP) experienced what happens when all this money heads for the exit. Utility stocks received similar treatment in late 2013, when investors foolishly sold the sector en masse amid concerns about the Federal Reserve’s plan to raise interest rates.
The conventional wisdom that utility stocks suffer when interest rates climb doesn’t reflect market history. In fact, the Dow Jones Utilities Average generated a total return of more than 60 percent from June 2004 to June 2006, when the Federal Reserve increased the benchmark interest rate by 425 basis points.
But the ability to buy and sell baskets of stocks in a single transaction can exaggerate the upswings and downswings in individual stocks, especially those with the heaviest weightings in popular ETFs.
Fortunately, the growing prominence of index-based strategies creates opportunities for active investors to take some profits off the table when valuations get stretched and add to their positions during irrational selloffs.
Utility stocks trade at expensive valuations after their most recent run-up.