After lagging the broader market last year due to a spike in 10-year Treasury yields, utilities stocks and exchange traded funds have reversed course, establishing leadership roles in 2014.
This year, utilities are the best-performing sector in the S&P 500, helping the Utilities Select Sector SPDR (NYSEArca: XLU) to rank as the best of the nine sector SPDR ETFs. XLU entered Friday with a year-to-date gain of 15.4%, which is slightly ahead of the rival Vanguard Utilities ETF (NYSEArca: VPU) and more than double the 7.2% returned by the S&P 500. [Utilities ETFs Remain Hot]
However, the combination of a more sanguine interest rate environment and the stellar performances offered by XLU, VPU and friends has some market observers concerned the sector is richly valued. On the upside, some analysts believe rate-sensitive utilities stocks can remain durable even if interest rates climb.
“Morningstar’s equity analysts view utilities companies as being slightly overvalued. Indeed, VPU trades at 106% of Morningstar’s equity analysts’ estimate of fair value,” writes Morningstar analyst Robert Goldsborough in a new research note.
As for XLU, the largest utilities ETF, the fund sports a P/E ratio of 16.5, which is slightly below that of the SPDR S&P 500 (NYSEArca: SPY), according to State Street data.
Even with the lofty valuations, a common trait of defensive sectors, investors have not been shy about allocating new capital to utilities ETFs. XLU has added almost $1.6 billion in new assets this year. In the second quarter, only eight ETFs added more new assets than XLE. During that time, the Energy Select Sector SPDR (NYSEArca: XLE) was the only sector ETF to add more new assets than XLU. [Where ETF Cash is Going]
Still, investors should closely monitor interest rate action as it pertains to the utilities sector.
“Since 2000, when interest rates began a secular decline, utilities companies have seen their investor bases broadened by those also seeking price appreciation in addition to income generation and reliability,” according to Goldsborough. “Now, Morningstar’s equity analysts believe that investors currently are pricing in 4% U.S. Treasury yields, so we don’t expect substantial moves downward from utilities if rates hit that level. At the same time, another way utilities companies could continue their recent outperformance would be if Treasury rates stabilized close to 3%.”
Last year serves as a good harbinger for what investors can expect out of the utilities sector when rates rise. XLU and VPU posted an average gain of 13.7% while the S&P 500 surged 32.3%. That is to say utilities stocks do not necessarily fall when rates rise, but they the sector can indeed be a laggard as rates move up.
Utilities Select Sector SPDR
Tom Lydon’s clients own shares of SPY.