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Argument 1:

A. Basic Fundamental Setup – Interest Rate Increases

Bond yields are falling. If: (a) bond yields continue to fall (i.e. signifying that there will be an increase in interest rates, as the yields move in inverse relationship to such rates); and (b) interest rate futures on the Chicago Board of Trade show that we may be facing a higher likelihood of increased or stagnant overnight lending rates, then we may see a potential decline in the Utilities Index as represented by the Utilities SPDR (NYSEARCA:XLU).

The mainstream theory is that utility stock prices are closely tied to interest rates. This conventional wisdom, which is based on a significant amount of empirical evidence, is that a gain in utility stock prices (and in particular, electric utilities) signifies that investors anticipate an interest rate decline, whereas a decline in utility stock prices signifies that interest rates are either rising or are likely to rise. There are two basic theories for this connection:

(a) Utilities are heavy borrowers. Interest rate declines, therefore, exert an unusually high benefit to their bottom line, and thus make utility stocks more attractive investments. (b) Utilities typically pay very high stock dividends, and when interest decline, the dividend yields of utilities become more attractive to those investors seeking the stable income embodied in these stocks.

Although some commentators have started to dispute this connection, it remains a largely mainstream view.

B. Current situation (as of close Friday) – Bond yields are declining and futures are betting that the Fed is increasingly unlikely to maintain the benchmark interest rate.

(a) Note yields are declining (i.e. interest rates are rising). Two year note yields fell 22 basis points, the most since the week ended June 27, to 2.49 percent. The price of the 2.75 percent security due in July 2010 rose 13/32 for the week, or $4.06 per $1,000 face amount, to 100 1/2, according to BGCantor Market Data. Yields on the 10 Year Treasury note declined 17 basis points, also the most since the week ended June 27, to 3.93 percent (source: Bloomberg Website, August 2, 2008).

(b) Futures Contracts indicate a higher chance that the Fed will leave its benchmark rate unchanged. Futures contracts on the Chicago Board of Trade on Friday showed a 37 percent chance the Fed will leave its benchmark rate for overnight loans between banks steady at its December meeting, compared with 12 percent a month earlier. The odds of an increase at its meeting Aug. 5 are 7 percent (source: Bloomberg Website, August 2, 2008). Based on this scenario, if: (i) interest rates continue to increase (as demonstrated by decreasing bond yields); and (ii) the Fed either maintains the benchmark rates or increases it, then the empirical history may point to a near-term decline in utility stocks.

Argument 2:

Technical Setup - Head and Shoulders Pattern on the Daily Chart

As of the current date, a major textbook head and shoulders pattern appears clearly evident in the daily chart for the Dow Jones Utilities Index (which is tracked by the XLU). This is an extremely bearish pattern, which commenced in March, and which may have the potential, based on the traditional reading of this pattern, to yield another approximately 20% loss.

While these chart patterns are not 100% dispositive or predictive, the presence of a strong head and shoulders pattern in tandem with the interest rate fundamentals may be a good harbinger of near-term negative performance in the utilities. A really good brief discussion of this pattern as it works out currently in the utilities is found on Tim Knight's blog. Tim Knight is a serious charts guru and I tend to take what he says fairly seriously.

A good way of benefiting from a potential decline in the utilities may be to purchase shares in the UltraShort Utilities ProShares ETF (NYSEARCA:SDP). On Friday, the XLU was down approximately 2.9%, and the SDP was up over 5.5%.

The thrust is that if we continue to see: (a) decreasing bond yields in tandem with higher futures expectations that interest rates will increase; and (b) confirmation of continued technical weakness on a shorter time frame, looking at factors such as the volume of the XLU on the decline in tandem with other momentum indicators such as the Relative Strength Index and the Commodity Channel Index, then shorting the XLU via purchasing shares in the SDP may be a great idea.

Disclosure/Disclaimer: The author does not yet hold any positions in the above securities as of the publication of this article and the contents of this article do not constitute investment advice and comprise solely the author's personal opinions.

Source: Time to Short the Utilities