The Utilities Select Sector SPDR (NYSEArca: XLU) is one of this year’s best-performing sector exchange traded funds. Until recently, XLU was actually the best performer among the sector SPDR ETFs, but has since been usurped by the Energy Select Sector SPDR (NYSEArca: XLE), the largest equity-based energy exchange traded fund.

Some market observers see growing risks to utilities stocks and ETFs, a group usually prized for being less risky than other parts of the equity market. 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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There is also something of a dichotomy at play when it comes to XLU’s near-term seasonality. While the utilities ETF is usually the best performer among the sector SDPRs in the month of September, Labor Day week can be tough time to be long utilities stocks.

Schaeffer’s Investment Research published a list Thursday of the worst-performing S&P 500 stocks during Labor Day week, noting “half of the stocks on the above list fall under the “Utility Gas” or “Utility Electric” umbrella. PPL, to start, has dropped in each of the past 10 Labor Day weeks, averaging a loss of 2.3%. Since hitting a seven-year high in mid-June, the shares have dropped 13.5% to sit at $34.55, and are poised to close the month beneath their 10-month moving average for the first time in a year. Further, PPL is struggling to stay in the black on a year-to-date basis.”

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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.

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