The Bull Market Is Fading: It’s Time to Get Cautious on Utilities

Source: Thinkstock

Source: Thinkstock

The best performing sector of the nine broad sectors represented in the S&P 500 has been the utility sector. The SPDR Utility ETF (NYSEARCA:XLU), which holds shares in utility companies found in the S&P 500 index has risen nearly 14 percent year to date.

The reason for this outperformance is twofold. The first is that interest rates have been falling, and this has created demand for higher yielding stocks. Utilities are a perfect example of such an asset class. Utility companies have very stable income streams and they tend not to have a lot of growth potential and so they use their cash-flow to pay high dividends. Even after the 14 percent increase, the XLU yields 3.4 percent, or nearly twice the dividend yield on the rest of the S&P 500.

Second, a major theme of the first half of 2014 has been that investors have been buying safer investments such as utilities with capital gains from the sale of high beta and high growth stocks, many of which have underperformed in the first half.

Nevertheless, we are starting to see signs that the bullish momentum behind the rise in utility stocks is abating, as is evidenced by the weak price action of the XLU over the past couple of days. I think that the correction could be deeper and longer lasting, and shorter term traders and investors should consider taking profits.

Here’s why.

First, the XLU is near a major resistance level—its 2007 peak. Typically when stocks or ETFs reach resistance levels short sellers and traders target them as potential shorts, and traders who have profits in these assets could choose these levels to take profits. This can generate selling pressure and push the XLU and its components lower.