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Question of the Week: The FOMC and Utilities Stocks

Q:  I’ve been reading Harry Dent’s book The Great Depression Ahead. Looking at the economic scene through a conventional lens, it sure seems like the Fed is setting us up for a massive wave of hyperinflation, witnessed by the exponential growth in M1 coupled with a decrease in production. However, recent history has turned much of conventional wisdom upside down. For starters, when have you ever seen commodities reach all-time highs while interest rates rest at 30-year lows? I’m very concerned with the macro environment, especially this fiscal corner we’re backed into. The Fed can’t raise interest rates because it will put the economy in free-fall, so they seemed to have chosen the lesser evil of the printing press. The net result seems to be a flight to commodities and higher-grade currencies. How will this affect utility stocks?

A: As I’ve pointed out before and again above, the impact of easy Fed money so far on utilities has been all positive.

Utilities were the last major sector to take a dive in last year’s market crash. One reason is that while the rest of the US economy was levering up this decade, these companies were paying off debt and cutting operating risk. As a result, when the bad times began to hit, their recession-resistant businesses were basically downturn proof, a fact they’ve proven time and again over the past year.

Utilities too, however, were caught up in the wreck that followed the mid-September 2008 demise of Lehman Brothers, as investors questioned the viability of everything outside of US Treasury bonds. The result of that plunge, however, has been that utility stocks have decisively left the “interest-rate sensitive” camp. In fact, they continue to act a lot more like cyclical stocks, whose fortunes rise and fall with the economy.

I think we can expect that to continue as long as the economy remains weak. For one thing, yields paid by strong utility stocks are still several percentage points above the benchmark Treasury rates, and valuations are a third where they were two years ago.

For another, with unemployment over 10 percent, it’s impossible to imagine wage-push inflation in this country.

That leaves commodity prices as the most likely spur for inflation. We don’t have that yet, but we could next year. For one thing, there’s been unprecedented demand destruction for commodities across the board since mid-2008, particularly for energy. Should demand return to that level energy prices are likely to go even higher than they did then.

As you know, I like to operate on the ground rather than at 30,000 feet, as Mr. Dent and others do. I think what we can do is buy good companies and diversify among areas that will benefit if we see more inflation (i.e. energy, stocks paying dividends in foreign currency), and I think the Utility Forecaster Portfolio fairly reflects this.

The feature article in the December UF (available now for subscribers at www.UtilityForecaster.com) shows how our Portfolio is prepared and discusses potential low-risk beneficiaries of inflation.