Time to Short the Utilities

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 (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 (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.

Comments

[fubar02:]

I submitted an article to Seeking Alpha on July 17th (three weeks ago) on this same issue when XLU was at 39.48 with exactly the same conclusion. It was rejected as being too technical as opposed to fundamental and was not accepted for posting. Once again, charts come in first.

2008 Aug 04 09:47 AM

[fubar02:]

For what it is worth, the author's fundamental argument is flawed. He states "(a) Note yields are declining (i.e. interest rates are rising)." When interest rates rise, note prices decline and their yield to maturity increases, not vice versa. His use of the word "yields" is incorrect. (From the technician).

2008 Aug 04 10:14 AM

[Max Rapaport:]

Fubar, thanks for this note.

2008 Aug 04 11:42 AM

[PAD:]

I disagree entirely. In the 2 years that the fed raised rates from mid '04 until mid '06 the utilities were one of the strongest groups out there. The UTY index was up 41% over that timeframe.

And every single month along the way i read the exact same articles saying utilities had to under-perform because rates were rising. And every single one of those articles was wrong.

Maybe the technical analysis angle is correct, i just don't follow that stuff.

Best of luck to everybody

2008 Aug 07 11:51 AM

[Larry House:]

I think the FED is on hold for a long time--many months. Interest rates are not going to jump soon. I see absolutely no reason to short utilities in general at this time. If there is a company-specific reason, that is different. Look at utility prices in months past when interest rates were higher. They were holding in pretty well then. I don't think they are going to break significantly even if the FED did start to raise rates. I don't see enough profit potential to short utilities.

2008 Aug 07 03:29 PM

[najdorf:]

The original article makes a trading argument with no reference to current prices (other than the bogus technical analysis). Many utilities have had a huge decline in pricing without a commensurate decline in earnings: for instance PCG is down 13% in the last year, while earnings have been solid, interest rates have come down a lot, and they've raised the dividend. This is for a 100% regulated utility with minimal risk other than SF political risk - it's been sold off along with the rest of the stock market. Particularly if the rally continues and investors continue to seek the stability of regular dividends in uncertain times, I can't see companies like this one losing significant additional market cap in the next year. Even if you're right on your directional call (i.e. the XLU drops some), shorting one of the most stable sectors after months of bear market isn't a high-profit-potential strategy.

Of course you could probably find some utilities that are over-leveraged, under pricing or regulatory pressure, or have mismanaged their supplies and derivatives. But you need to do the research to come up with a good specific short - shorting a fairly boring sector ETF based on a shallow interest-rate guess is not going to produce impressive profits. Interest rates are notoriously difficult to time because the market anticipates them and they don't always have the effect you would expect. If you really think you can outpredict the market on rates, you should be a bond investor, where at least your guess has a direct effect on pricing.

2008 Aug 12 11:49 AM

[fxtrader07:]

stocks and sectors offering a high and highly rfeliable dividend yield have come under severe pressure over the past 12 months.
this has created exceütional opportunities going forward as dividends will once again be the major contributir to total stock market returns over the rcoming 4-5 years. So shorting utilities might not be so smart a move. That being said, there are far more compelling dividend plays out there - e.g. in the MLP sector, certein reits and selected financial stocks like acas

2008 Aug 14 03:43 AM