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Special Situations for Undervalued Utilities

By Richard Stavros on May 20, 2016

The biggest challenge today for income investors is finding reasonably priced investments. Thanks to their safe-haven status, most dividend stocks have become overvalued following the market’s tumult earlier this year.

The question most often asked at our Wealth Society’s annual summit, held last week in Las Vegas, was whether there are still undervalued opportunities in the utility space.

While most utility stocks are pretty expensive at the moment, there are two macro events over the next month that could create buying opportunities: 1) a potential rate hike by the U.S. Federal Reserve; and 2) the U.K.’s possible exit, or Brexit, from the European Union.

At Utility Forecaster, we’ve written a number of times about how a more hawkish Fed could help bring utility valuations back to Earth. And at our sister publication, Global Income Edge, we’ve noted that uncertainty over the so-called Brexit could also create buying opportunities for value-conscious income investors.

The U.S. central bank’s minutes from its April policy meeting were released on Wednesday, revealing a more hawkish outlook on rates than the market had expected. That could mean a June rate hike is on the table, which could cause utility stocks to sell off.

We got a small taste of that during Wednesday’s afternoon market session, when the Dow Jones Utilities Average quickly dropped 2% after the minutes were published. The utilities benchmark has since recovered somewhat.

Last year offered plenty of evidence that mere Fed jawboning can still cause dividend stocks to sell off. The utility sector suffered three Fed-induced corrections in 2015, and only one of those involved an actual rate hike. All three corrections turned out to be good opportunities to pick up some of our favorite stocks.

Fed policymakers indicated that a June interest-rate increase would be likely if the economy continues to improve, boosting market expectations they will act next month. Traders adjusted their bets accordingly, with the probability of a June rate hike jumping as high as 33% at one point from just 5%, according to futures data aggregated by Bloomberg. It has since declined to 28%.

Regardless of what the central bank does in the near term, we continue to believe that rates will stay lower for longer, and that utility stocks will continue to be attractive amid weak growth in both the U.S. and overseas markets.

Then there’s the possibility that a Brexit could roil global markets, especially since some observers worry it could presage the fall of the Continent’s currency union.

But we’ve seen this show before. Last year, Greece’s potential exit from the E.U. sparked market selloffs that created buying opportunities.

Although polls suggest that British voters will choose to remain in the E.U., as we get closer to the country’s referendum on June 23, there could be more downward volatility. That could be another chance to pick up some of our top stocks.

For subscribers, we highlight two favorites that could drop to more attractive levels over the next several weeks.

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