Utilities Are Warning of a Correction: Part 2

Includes: DIA, IDU, IVV, SPY
by: Michael A. Gayed, CFA

On March 9th, I published an article here on SeekingAlpha titled “Utilities are Warning the Correction is Here.” In it, I argued that the outperformance that Utilities were exhibiting in the weeks prior to publication was suggesting that risk assets would not fare well and that a correction may be occurring.

The reasoning behind this is that the Utilities sector is perhaps the most sensitive sector to the direction of interest rates. Why? Because interest costs in highly leveraged infrastructure companies derive less of their earnings from revenue growth, and more from the cost of capital. Utilities have historically been a way for equity investors to bet on the bond market while still getting exposure to stocks.

Utilities also can be considered a “risk-off” sector, in the sense that investors don't pile into the group for capital appreciation, but rather for the (perceived) safety of dividends. In other words, because dividends make up the largest chunk of Utilities' total return, when stock markets become volatile, Utilities becomes a safe-haven from price variability.

The market was indeed in the middle of a correction, but quickly “V-ed” off of its low, putting a stop to the decline and causing Utilities to underperform. I suspect this occurred because the Bank of Japan, in an effort to stave off a financial crisis which could have formed following its earthquake and tsunami, pumped record amounts of new money into their economy. This new money almost acted like a mini QE, and may have indeed leaked out into other global equity markets.

So what are Utilities signaling now? Take a look below (click to enlarge) at the price ratio of utilities (NYSEARCA:IDU) to the Dow (NYSEARCA:DIA). As a reminder, a rising price ratio means the numerator/IDU is outperforming (up more/down less) the denominator.

Click to enlarge

The peak of the ratio coincided with the bottom for the S&P 500 this year. Notice, however, that the ratio is actually ticking higher, meaning Utilities have been showing outperformance into absolute strength for the overall market indices. The conclusion? We may very well be at the early stages of another period of declining prices for stocks.

Disclosure: Pension Partners, LLC, and/or its clients may hold positions in securities mentioned in this article at time of writing.