The S&P 500 Utilities index has been on a tear. We have long favored utilities stocks at Young Research & Publishing. Last year when many investors were dumping utilities we were advocating new positions (see December 2013 Global Investment Strategy – subscription required). The consistent dividends, high-barriers to entry, and regulated returns have appeal for serious long-term investors. But the strength of the recent upleg might not be all roses and butterflies.
The S&P 500 Utilities index is up a staggering 34% YTD making it the best performing sector in the index. Over half of those returns have come over the last three months. This is remarkable performance for a sector with low single digit growth prospects. Surely the market can’t just be forecasting an improved environment for utilities.
So why might utilities stocks be so strong? There could be many reasons, some of them benign, but some quite disturbing. Part of the strength in utilities could just be window dressing and momentum chasing. Utilities are the best performing sector YTD so fund managers are likely piling in at year-end. Likewise, the momentum crowd is undoubtedly piling into utilities stocks regardless of the underlying fundamentals.
Those are the more benign scenarios. The more concerning possibilities are that the strength of utilities stocks is due to yield chasing. The Fed and other global central banks have deprived investors of yield. Some investors are surely giving up on bonds and piling into income stocks. The closest substitute for a bond is probably a utility stock. Why is this a concerning trend? Yield-seekers are hot money investors. When they flee, prices could fall just as fast as they have risen.
The strength in utilities could also be sending a signal about the business cycle and/or the bull market. Utilities tend to outperform in the late stages of a bull market. Could the market be sending a subtle signal that the bull market’s days are numbered or that the economy is much closer to recession than is widely believed. It would be foolish to rule out such a scenario.
Whatever the cause, with values in the utilities sector much less appealing than they were only 12 months ago, long-term investors would be well served by taking a more discerning and discriminating approach to investing in the utilities sector.