Utilities Price Action Bearish as Bond Yields Decline

Montreal, Canada

Back in December, I purchased XLU, or the SPDRs Utilities ETF, on the premise that income-producing stocks with steady earnings would continue to outpace the broader market in a sluggish economy. But the short-term price action for this sector has turned bearish lately and now warrants investor caution.



The Dow Jones Utilities Average (DJUA) is down 7.7% this year versus a 1% decline for the Dow Jones Industrial Average. The DJUA peaked in December and has since pulled back, violating important support levels.

Utilities don't do well in a rising interest rate environment because they're interest rate sensitive stocks. The correlation with bonds has historically been strong; over the last ten years utilities have handily outpaced the Dow and the S&P 500 Index, mainly because of their dividend stream and low interest rates.

As Treasury bond yields came under pressure last year utility stocks defied the primary trend and recovered along with the broader market. But even as Treasury bonds have rallied lately the utilities sector has consolidated – a bearish sign. Last week, yields on the benchmark 10-year Treasury bonds declined from 3.78% to 3.61%; the DJUA declined 2.1% over this period.

Utilities yield an effective 4.3% yield compared to 2.1% for the S&P 500 Index. That's more than twice the effective rate paid by the broader market, which is expensive. And compared to ten-year Treasury bonds, utilities offer not only a higher yield but a better after-tax return before the expiration of the Bush tax cuts next year; dividend tax rates will jump to 39.6% in 2011 from 15% now.

In a muddle-through economy, fat dividends are worth a lot. And the DJUA should continue to outpace the broader market over the next several years if interest rates remain stable. Increasingly, however, it looks like interest rate sensitive stocks are losing technical support, discounting bad news on the interest rate front. I can't make a case for a rapid series of rate hikes by the Fed any time soon. The economy can't handle high rates – especially a still badly wounded housing market. Still, the price action of utilities this year is not bullish for the economy or the market.

I've downgraded utilities to "hold."

The big risk to utilities and most stocks for that matter is when and not if, America's lenders balk at financing an ongoing wave of Treasury auctions in the absence of meaningful deficit reduction. Unless the United States controls its profligate spending soon the market will be forced to take interest rates much higher to finance her deficits. And that won't be good for utilities.

Average rating
(0 votes)