A Sell-Off In Utilities And What Is Next For The Market

Includes: AEP, DUK, ETR, VPU
by: Brendan O'Boyle

It is a testament to investor paranoia that even the most boring of sectors is currently experiencing a panic sell-off. To wit, consider the performance of utility stocks over the past few weeks of trading.

Figure 1: Comparing the Dow Jones Utilities Average Vs. Dow Jones Industrial Average YTD Performance.

Remember utilities? They were the best performing sector of the S&P 500 last year and not surprisingly one of the worst performing sectors so far this year. The TTM P/E for the Dow Jones Utility Index is 20.45 vs. 14.45 for the Dow Jones Industrial Average. However, the dividend yield is 4.35% for the former and 2.67% for the latter. Last year investors threw in the towel on stocks and bid up the price of utilities figuring at least they would at least receive the dividend. Unfortunately the relative underperformance of the sector has more than offset the added dividend yield in the past twelve months.

Interestingly, the current sell-off is the first time utilities have underperformed the market during a downturn. Look at the graph below, industrials have outperformed utilities even during a market sell-off. So a tried and true "safe" sector has underperformed a "dangerous" cyclical sector, while the market has turned down. As a reminder, the blue line is the price of the S&P 500, while the black line is a ratio of VIS/VPU. A rising black line indicates cyclicals are outperforming relative to utilities, a trend that is typically associated with more aggressive risk taking in the market.

Figure 2: Comparing the S&P 500 Vs. the Ratio of VIS/VPU.

My interpretation of this recent price action is that political uncertainty over future taxes is overshadowing any fears about a downturn in the economy. The lack of selling pressure in consumer cyclicals shows the market is not discounting fears about growth, it is instead discounting fears of how the tax code may soon change. If you as an investor believe the economy is weakening, then the rally is to be sold as growth fears are not being discounted regardless of the 50 points the S&P 500 has shed since QE3 was announced. On the contrary, if you believe the economy is reasonably sound and fiscal cliff fears are overdone, then holding is the most desirable decision.

Personally, I lean toward the latter conclusion, unless the Democrats and Republicans are unable to reach some kind of bargain. If no deal is announced, it seems likely that the markets will become more and more erratic as the year draws to a close. The longer this rally runs without any real news, the more exposed it will be to fears about the fiscal cliff.

While I have expressed skepticism of utilities as an investment class I have to admit the current knee-jerk pullback has the appearances of a buying opportunity. Utilities are desirable for the dividends they produce in a ZIRP environment. Additionally, this situation is very unlikely to change anytime in the foreseeable future. Furthermore, the fears of raising taxes on dividends seem to miss the point. Capital gains tax rates are also set to rise as are taxes on the coupon payments you receive for most bonds. Thus a change in the relative valuation of utilities as an asset class compared to other asset classes does not make intuitive sense. Consider the figure below which shows the rate of return on a BAA corporate bond to the dividend yield of the American Electric Power Company (NYSE:AEP).

In the past, the rate of return on a BAA corporate bond has nearly always exceeded the dividend yield of American Electric. Currently the dividend yield is 4.56%, while the dividend yield of AEP is 4.60%. On this basis, utilities as an asset class look relatively cheap compared to bonds. If your desire as an investor is to generate income, the recent sell-off represents a good buying opportunity. Exposure to the sector could be obtained through the purchase of individual stocks, or by an index fund, such as Vanguard's Utilities ETF (NYSEARCA:VPU).

As mentioned above, utilities as a sector seem somewhat overvalued, thus picking a few reasonably valued stocks from within the sector seems to be a preferable strategy. American Electric Power Company seems attractive in this respect at 12.6x TTM earnings, 17.6x CAPE 10 year average earnings and 1.3x book value. Duke Energy (NYSE:DUK) also seems attractive (19.1 TTM PE, 20.9 CAPE, 1.03 Price to Book, 5.10% Dividend) and Entergy (NYSE:ETR) (15.6 TTM PE, 11.6 CAPE, 1.20 Price to Book, 5.30% Dividend).

Each of these utilities has a very reasonable valuation and has presented investors with slow but steady dividend growth over the past ten years. However, utilities have uniformly low return on equity, no comparative advantage between firms, a capital intensive business model and low growth. On the other hand, the stocks identified above pay approximately 5% in dividends. A good rule of thumb is the total return you can expect from an investment is the dividend plus growth: The 7% total return should prove to be a reasonable expectation, which isn't too shabby.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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