Utilities: Time for Caution?

06/06/2016 9:00 am EST

Focus: ETFs

Joon Choi

Senior Portfolio Manager, Research Analyst, Signalert Asset Management LLC

In August 2015, I recommended that it was time to get defensive; since that recommendation, we have experienced two stock market corrections; one last summer and other at the beginning of this year states Joon Choi, editor of Systems & Forecasts.

At that time, we switched our holdings from SPDR S&P 500 (SPY) to defensive sector ETFs – namely, the Consumer Staples Select SPDR (XLP) and Utilities SPDR (XLU).

Utilities has been a very good investment for 2016 so far; as the sector outperformed the S&P 500 by 9% with less volatility to boot.

And while both of these recommended ETFs outperformed the market, I believe this is a good to re-evaluate whether it’s been worthwhile to be in defensive sectors.

I am beginning to dislike the sector as the space has become too crowded. Rotating some positions out of utilities may be warranted because of two additional reasons.

First, there is the possibility of a summer interest rate hike. And it now appears that the Fed may enact a second interest rate hike by September and maybe even another one before the year-end.

This may spell trouble for utilities because dividend yields may not be as attractive when competing bond yields go up.

In addition, most utility companies have little, if any, growth potential which means investors are almost solely focused on dividend yields which are currently at 3.3%.

We also see excessive valuation from a historical standpoint; the trailing 12-month P/E ratio for the utilities sector is at its highest level in the last 31 years.

The ratio reached 33.7 a few weeks ago which surpassed the previous high of 30.5 in 2001. This new high was obtained through drastic movements in both price and earnings.

Prices have been driven up by investors favoring the sector while earnings have decreased in the recent quarter; a larger numerator and a smaller denominator in the P/E ratio led to the abrupt increase.

The last time the utilities sector saw a similar spike in the valuation measure was in 2001, where a 51% decline ensued. I do not believe we will see the same type of sell-off but we may see a sizable correction of 10% or more.

However, the P/E ratio of the sector recently reached a historically high level which suggests that XLU may be over-valued. Therefore, I am recommending to stay out of the utilities sector for the time being until the valuation comes down.

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By Joon Choi, Editor of Systems & Forecasts

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