A Cautious Approach to a Popular Dividend ETF

High-yield dividend stocks and exchange traded funds have been rewarding yield-starved investors for much of this year, but that trade has recently been threatened on concerns that defensive sectors, such consumer staples, telecom and utilities, are overvalued and that the Federal Reserve could be nearing its first interest rate hike of 2016.

A desire for defense and yield benefited ETFs like the Shares Select Dividend ETF (NYSEArca: DVY), which was one of the better-performing dividend exchange traded funds through the first half of this year.

Related: Low U.S. Interest Rates Boost International Dividend ETFs

Downside risk 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

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.

“I would anticipate the most interest-rate sensitive names have already adjusted for whatever interest rate chatter will be drawn from today’s release. Utilities and REITs have already retreated 10% off recent highs. REITs have struggled more than utilities here, but I anticipate both will walk lock-step into the end of the year,” reports Timothy Collins for TheStreet.com.

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.