Are Utility Stocks Becoming Risky?
The market had its best week of the year, with the NASDAQ hitting its best level in 13 ½ years (1) Janet Yellen, the new chair of the Federal Reserve Bank, helped the market get moving forward again with her initial Congressional testimony. The catalyst for the move came when she reiterated the Fed’s plan to continue tapering and also again deferring the raising of interest rates to some undetermined future time.
Speaking of interest rates…
Okay – not a great segue. Nonetheless, rates are one of the causes of why utility stocks have enjoyed very nice gains over the past few years.
My disclaimers are that this is not related to either/any individual utility companies or the industry. My comments refer to the sector as a whole. The investor risk I see with these is one related to market cycles and math – not a company. We’ll do the math part first.
With interest rates having dropped and remained low for the past few years now, utility companies have enjoyed a positive perfect storm for their shares. Since this is a highly capital-intensive industry (uses lots of money in the conduct of their business), they’ve benefited from the low short and long-term rates. In addition, with their long-established history of paying above-average dividends to shareholders, savers – who have found CDs, money markets and the like to not be paying at rates they wanted – have sought out high dividend shares. Together with this premium cash flow, they’ve seen these shares as safe (aka, low price fluctuation).
As a result, the demand helped boost share prices – as did the direction of interest rates over the past 30 years. Here’s why.
Because of the high predictability of the dividend payments, utility shares tend to trade more as bonds than does the typical stock. As such, this means that those shares would have been inclined to rise as interest rates fell. That’s because bonds and, to an extent, utility shares will see their values move in the opposite direction of the trend of interest rates. With rates having pretty much just dropped from 1982 until late last year, shares have had an additional boost up.
Until now…
Why utilities may now be at the top of that long ride up the first roller coaster hill…
I see two reasons.
First is that it doesn’t seem too likely that interest rates will be going further down. With the economy picking up and the Fed ultimately allowing the market to set the rates, the trend of rates will likely be higher. Along with that is the increasing chance that upward action will put downward pressure on utility share prices.
Another is simply the cyclicality of markets. When a sector has had a particularly good run, at some point, it will see share prices lower in order to begin the cycle again. Here’s a fine demonstration of that.
On Friday, Savita Subramanian, Equity and Quant Strategist at BofA Merrill, put out this note. “Utilities is now once again the most expensive sector vs. history on relative forward P/E (eclipsing Financials); it trades at a 3% premium to the market when it has historically traded at a 14% discount.” You might want to Google, “reversion to the mean”…
My take? What’s gone up is now waxing its skis to come down…
What to do?
So, to answer the title question – maybe.
Dividends will likely continue – I don’t see that as a major risk. However, it’s the prices per share continuing around these levels that I see as the primary risk.
If you would like to capture some of these historic highs before they become one of those, “I should have…” comments down the road, I suggest you and your advisor should review your holdings to see how and what best to do.
If you share our view that growth represents the new value, an alternative could be shares of other quality companies with a history of, and potential for, dividend growth. Some current income could be lost but that potential for total return growth, share prices and dividend amounts, might be a lot more meaningful to you over time.
Cheers!
Mike
509-747-3323
(1) CNBC, 14 Feb 2014
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