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First a Fake-Out, Then a Tantrum

Utilities have been on a wild ride over the past month.

Four weeks ago, the sector appeared headed for a much-needed correction. But as stocks approached formal correction territory in mid-September, they suddenly reversed course only to just as suddenly reverse course again a week later.

This head-spinning action led to 10 consecutive days of declines, with the sector finally entering a correction on Tuesday. A formal correction is marked by a decline of 10% or more from a recent high on a closing basis.

We believe such a correction is ultimately healthy for the sector, even though watching our favorite stocks drop for 10 straight days is unnerving, to say the least.

Utility valuations had become stretched in recent months, with some stocks trading at absurd multiples. Consequently, in the August issue of Utility Forecaster, we advised subscribers to consider rebalancing their portfolios, which essentially involves taking partial profits on winning positions and reallocating the proceeds to laggards.

Utility stocks raced ahead of the market this year partly due to the fear trade and partly due to historically low interest rates. And at a certain point, both of these factors became intertwined.

In addition to the Federal Reserve’s holding pattern on short-term rates, which remain near an all-time low, fearful investors piled into risk-free assets, such as benchmark 10-year Treasuries, whose yields hit a record low of 1.32% in July.

Meanwhile, a significant portion of global debt has actually been trading with negative yields, which means investors are willing to lose some money in exchange for safety. According to Bloomberg, the total face value of negative-yielding debt was around $11.6 trillion at the end of September.

While that staggering sum is down about 2.5% from the June peak, it still accounted for nearly a quarter of the debt tracked by the Bloomberg Barclays Global Aggregate Index.

That’s forced income investors of all stripes, even institutional investors who might normally invest in bonds, into utilities. As such, utilities became a crowded trade.

Earlier this year, when we pondered what might finally cause utilities to correct, we figured the Fed would probably be the culprit.

The customarily cautious central bank appears to be laying the groundwork for a December rate hike. And while economic data are hardly robust, they appear to be sufficient to persuade investors that the Fed is finally getting serious again about raising rates.

According to futures data aggregated by Bloomberg, a majority of traders are betting on a quarter-point rate hike at the Fed’s December meeting.

This time around, the Fed appears to have also gotten an assist from the European Central Bank and the Bank of Japan, both of which have sent confusing signals that the market has interpreted as implying monetary tightening.     

That’s precipitated what could be the beginning of a taper tantrum: Dividend stocks are declining, while bond yields are climbing.

Utilities’ recent decline, therefore, is not driven by anything having to do with sector fundamentals. Instead, this action is similar to the three Fed-induced corrections that occurred last year.

Nevertheless, the Fed’s own projections of future rate hikes have further weakened–the long-run rate is a pathetic 2.9%, and policymakers don’t expect to get there until sometime after 2019.

That means utilities should continue to command a premium relative to their long-term valuations for the next few years, even if they occasionally suffer periodic corrections, such as the one that’s happening right now.

Despite the recent decline, utilities are still up 11.4% year to date, about 6.0 percentage points ahead of the broad market.

Last year, we used each sector correction as a buying opportunity. We intend to do the same this time around. For subscribers to Investing Daily’s Utility Forecaster, we’ll highlight a few of our favorite utilities that are trading at compelling valuations again in our weekly update.

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