If you follow my investment views, you know that for the past two years, the utilities sector has been one of my least favorite areas of the market. During that time, the sector has lagged the performance of the broader market by approximately 18%, thanks primarily to the sector’s sensitivity to rising rates and its high valuations.
However, as I write in my latest weekly commentary, I’m now no longer as cautious toward the sector for two reasons.
1.) While I expect that long-term interest rates will continue to rise, I believe that further long-term rate increases will be modest. Since the utilities sector is often seen as a proxy for the bond market, the rates backdrop is important to that sector. I’ve discussed before that shorter-duration assets (meaning bonds with maturities in the 2- to 5-year range) are likely to be the most vulnerable part of the bond market in 2014. In contrast, longer-duration areas of the market have already seen an increase in interest rates and any further upward rate action in that area is likely to be less severe than was the case in 2013. As a result, a more stable long-term rate environment should take some of the pressure off of sectors, such as utilities, that are sensitive to long-term rates.
2.) Utilities stocks are no longer as overvalued as they have been for most of the past two years. Utilities companies typically pay a relatively high dividend rate, and with investors desperately searching for income, the sector captured significant inflows in recent years. As a result, valuations for utilities stocks become inflated. However, today, while the sector still looks expensive relative to its long-term average, valuations have fallen. Given utilities’ underperformance, the sector now trades at a discount to the broader market. Specifically, valuations for the utilities sector have contracted by around 10% since last April, and large-cap utilities companies now trade at a 10% discount to the broader market (versus a 5% premium in the middle of 2012).
So what does this mean for investors? From a portfolio construction perspective, I’m moving my view of the sector to a “neutral” from an “underweight” stance. In other words, I’m now advocating that investors hold the sector at a benchmark weight. Still, I believe that there are other defensive areas of the market that offer more value (notably healthcare). You can read more about my various sector views in my latest Investment Directions monthly outlook piece.