The Utilities Select Sector SPDR (NYSEArca: XLU) is one of this year’s best-performing sector exchange traded funds as the combination of the Federal Reserve holding off on raising interest rates and investors favoring low beta corners of the equity markets has lifted defensive sectors.
However, the downside is that utilities stocks are trading at frothy valuations, prompting some concern by market observers over how long the defensive rally can last. The utilities sector is trading at heightened valuations after investors plunged into the defensive play in search of yield and safety in an environment of historically low yields, slow growth and geopolitical uncertainty.
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Looking ahead, FactSet projects the utilities sector is expected to experience earnings growth of 4.4% in 2016. Consequently, analysts warned that the lofty prices may not be supported by robust earnings growth. The trailing 12-month PE ratio for utilities of 19.85 is now higher than that of the more volatile technology sector at 19.16.
Still, there is a case for remaining long defensive sectors, particularly as Election Day draws closer.
“Defensive stocks like utilities tend to be down when the growth stocks are up; they are counter-cyclical. So if the probability of US stocks declining is greater than 66% it may be that investing in utility stocks is a good move here,” according to See It Market.[related_stories]
The fortunes of the utilities sector seem to be tied to the Federal Reserve’s interest rate outlook. Once the Fed eventually hikes interest rates, the higher rates will make fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing. Consequently, utilities may remain flat or underperform other segments of the equities market once rates start ticking higher.
Given the utilities’ dividend association, the sector is also found in many dividend-focused ETF strategies. For instance, the iShares Select Dividend ETF (NYSEArca: DVY) is the second largest dividend-related ETF on the market, with $15.2 billion in assets under management, and the ETF includes a hefty 31.7% tilt toward utilities.
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DVY could see further upside because the Fed may not be able to raise interest rates as much as previously planned this year, which would keep pressure off utilities and consumer staples names.
Tom Lydon’s clients own shares of DVY.