Utilities (gas, electric and water) are the top performing stock market sector year to date in 2016 (energy is a close second and materials are a not far behind third). Historically, utilities are a safe haven investment that performs better in falling interest rate environments common in bear markets. Yet, the Fed began increasing interest rates in December and the U.S. stock market has rallied since mid-February. Nevertheless, utilities have held their top spot, at least so far, with an approximate 11% increase compared to only around 2% for the S&P 500. Unlike other areas of the market, such as transportation, where there are only a few ETFs covering the industry, investors have a plethora to choose from in the utility sector.
Investors should not automatically assume that utilities will maintain their early year rally. If it becomes generally agreed that the U.S. stock market has turned bullish (the weight of opinion seems to be on the bearish side at the moment) or longer-term interest rates begin a steady rise, then utility stocks will lose their popularity. Investing money tends to move to the best performing sectors, and energy and basic materials are now giving utilities competition. Along with the industrial sector, they could assume the top three spots. This would be a very different type of bull market than in the 1990s, when tech stocks led the way or the early 2000’s rally when FIRE (finance, insurance and real estate) were the hot stocks. In the post-2008 rally, healthcare, consumer discretionary, and the technology sectors have led the market.
The chart below shows the performance of the utilities sector (NYSEARCA:XLU), the energy sector (NYSEARCA:XLE) and the materials sector (NYSEARCA:XLB) compared to the S&P 500 (NYSEARCA:SPY). Utilities is the golden line, energy the blue line and basic materials the red line. Note that for a short period in late April, energy was the top performer and basic material the second best sector performer.
The Three Top Performing Sectors Year to Date in 2016
Utilities are heavy borrowers and higher rates lower their profits. They have the highest long-term debt to equity ratios of all stock sectors. This is not true across the board, however. Electric and diversified utilities tend to have much higher long-term debt to equity ratios (up to almost three times as much on average) than gas utilities. While the Fed may be raising its overnight Fed funds rates (and a June hike now seems quite possible), long-term treasury interest rates have been generally falling so far in 2016. The dividends on utility stocks, sometimes the highest in the market, but currently beaten by the basic material, consumer goods and financial sectors, also compete with yields on bonds. Lower risk bonds become competition for utility stocks when Treasury yields are higher. In the chart below, the black line represents the yield on the 10-year Treasury, the golden line the 7-year Treasury, and the blue line the 5-Year Treasury.
Ten, Seven and Five Year Treasury Yields
While U.S. utility funds have had good returns in 2016, the same is not true for foreign utility funds. ETFs that represent the U.S. utility stocks: XLU, VPU, FXU, IDU, RYU, PUI, and FUTY have had returns of 13.2% to 13.5% up to mid-May. As can be seen, there is very little difference in return. Global utilities ETFs: JXI, DBU, and IPU have had returns of 7.7%, 4.0%, and 1.5% respectively. For the moment, utility investors should avoid these.
Whether or not investors want to hold utility stocks going forward depends on their preference for risk and desire for income. Investors who have a long-term perspective, want less volatile stock investments and a regular dividend check should certainly hold at the moment. Making any significant new investments is not advisable if we are entering a rising rate environment. This will not favor utility stocks in general.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.