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.

Second, one of the reasons that investors have bid up shares of utilities is that interest rates have been falling. But we are seeing this trend reverse. If interest rates rise then the relative appeal of utilities begins to fade and this leads to selling pressure. Note that one thing investors should do if they are interested in utility stocks is to watch the iShares Barclays 20+ Year Treasury Bond ETF (NYSEARCA:TLT). If it makes a new high above its May peak of $115.19/share then we could see a further decline in interest rates, and this would generate further investor interest in the utilities sector. But if the fund continues to decline then this weakness will put pressure on utility stocks.

Third, utility companies are facing a lot of regulatory scrutiny considering the EPA’s recent restrictions on coal production and burning. Utility companies could have to spend a lot of money upgrading their facilities in order to comply with EPA regulations, and these costs will either eat into the companies’ margins or they will be passed onto consumers, who in turn will use less electricity. Either way the utility companies lose. One way around this is to single out utility companies that generate most of their revenues from other energy sources such as nuclear power or natural gas.

Ultimately the utility sector has had a great 2014 thus far, but it is starting to run into resistance—both technically and fundamentally. As a trader it would be wise to take some profits or to use a stop order in order to lock in gains. If you are an investor who wants exposure to the utility sector you should wait for a pullback or look closely at individual names in the space to find companies with qualities that set them apart from the pack.

Disclosure: Ben Kramer-Miller has no position in the funds mentioned in this article.

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