Portfolio Update

What to Wear: Rally Cap or Hard Hat?

Thus far in 2016, utilities and telecommunication services have emerged as the top-performing sectors in the S&P 500, delivering total returns of more than 20 percent at a time when the overall index has eked out a 6.57 percent gain.

(Click graph to enlarge.)

Although we’ve argued in the past that some utility stocks deserve a premium valuation because of their underappreciated growth prospects related to the rollout of renewable energy and gas-fired power plants, the sector’s recent momentum-driven upsurge has outstripped underlying fundamentals.

Much of this upside reflects the appeal of utilities’ resilient cash flows and above-average dividend yields at a time when the US economy continues to grow at a lackluster pace and the Federal Reserve appears unlikely to hike interest rates again this year.

Unfortunately, stretched valuations in the utility sector suggest that the recent momentum-driven gains won’t last.

Historically, the risk of a pullback is elevated whenever the Dow Jones Utilities Average trades at more than 20 times earnings and yields less than 3 percent—one of the reasons we recently reiterated our calls for Conrad’s Utility Investor subscribers to consider taking some profits off the table.