Why Dividend-Paying Utility Stocks Will Lead the Market Higher

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 |  Includes: IDU, RYU, UPW, VPU, XLU
by: Rising Dividend Investing

Somewhere in Washington DC Ben Bernanke is surely smiling, if only slightly. In recent weeks, stocks have been rising and last week the Utility Index (NYSEARCA:XLU) broke to a new 12-month high, signaling that investors may be willing to take on more risk.

Amid all the worries Ben carries on his shoulders about the viability of the US economy, he has to constantly be aware of the shifting moods of the players, consumers, and business people, in the current unfolding economic drama. Ben knows what he needs most right now is a catalyst to lift the "animal spirits" of the players so they will return to more normal consumption and investing patterns.

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There has been precious little "feel good" news in the economic data for most of 2010. Home prices are still wallowing at low levels; unemployment is still sky high; and until recently, stock prices have flat-lined.

There has, however, been lots of good news in the earnings reports of major corporations. But with all of the ill winds in the economic news, many investors have concluded that these earnings increases are the result of expense reductions and layoffs and will only make the US economy worse.

Ben is smiling because he knows the earnings are real, and that rising earnings will ultimately lead to job growth. He also knows that rising stock prices in the face of poor economic news are a good sign because it means that investors are beginning to look through the current malaise to better times.

The utility index breaking to a new 12-month high is important because, as we have said before, utilities are generally considered to be bond substitutes. Their dividend yields are more than double that of the average stock; they usually operate with some kind of monopoly power, and their financial ratings are higher than the average stock.

History shows us that almost all major turn-arounds in stocks have been led by the utilities. As investors become more confident and begin to move out of bonds, their first landing place is usually in the stock sector they consider to be the safest. For most people that is the utilities. Thus, it is not surprising that in the recent uptick in stocks, utilities have broken above their 12-month highs, while the S&P 500 Index is still nearly 3% under its 12-month high. We would expect that the S&P 500 will follow the utilities lead and break to a new intermediate high by the end of the year.

This move will be driven by the recognition that stocks are cheap compared to bonds and that Ben will see to it that bond yields won't be rising anytime soon.