Utilities ETFs Showing Troublesome Signs

For over three years, the utilities sector has been a leadership group, cementing the notion that investors have been somewhat apprehensive about the broader market rally.

As investors have searched for yield while pouring billions of dollars into low volatility broad market and sector fund, utilities stocks and ETFs have flourished.

By the standards of a supposedly slow-moving sector historically low correlations to the S&P 500, the year-to-date gains accrued by the major utilities are jaw-dropping. The Utilities Select Sector SPDR XLU, the Vanguard Utilities ETF VPU and the iShares Dow Jones US Utilities Index Fund IDU are all up more than 18 percent this year. The SPDR S&P 500 SPY is up nearly 14 percent.

Maybe a true risk on rally is forming, but utilities ETFs have been far outpacing riskier fare this year. For example, all of the aforementioned utilities funds have outpaced the tech-heavy PowerShares QQQ QQQ by more than 700 basis points year-to-date.

However, there are signs some of the air is starting to come out of the utilities trade. XLU, the largest utilities ETF by assets, is down 1.2 percent Monday while the S&P 500 is modestly higher. That extends XLU's five-day loss to over two percent. The Vanguard Utilities ETF, the cheapest utilities fund with an expense ratio of 0.14 percent, is also lower by more than one percent Monday and has lost 1.8 percent in the past five days.

Part of the problem could be sector rotation as investors that are looking to be long stocks go shopping for what they perceive to bargains or good deals. On a valuation basis, the utilities sector does not offer "good value." Nearly a year ago, Benzinga noted XLU was sporting a P/E ratio of 15.4.

That is toward the higher end of historical norms for the sector. From June 19, 2012 through the end of July, XLU would gain about $1.20 before wilting through much of the third quarter. XLU and friends would later be hammered by fiscal cliff fears.

At least that was the easy excuse to use and it was convenient because it ignored the frothy valuations seen in the utilities space. These days, XLU sports a P/E of 16.77 and a price-to-book ratio of 1.72, according to State Street data. In other words, XLU is more expensive today than it was 11 months ago.

The iShares Dow Jones U.S. Utilities Sector Index Fund is no bargain, either. That ETF has a P/E of nearly 22 and a price-to-book ratio of 1.86, according to iShares data.

Still think utilities are not pricey? Well, Google GOOG trades at 16 times forward earnings. The Technology Select Sector SPDR XLK allocates a combined 21 percent of its weight to Apple AAPL and Google has a lower P/E than XLU.

The aforementioned utilities can stay expensive for extended time periods. These funds have already proven as much, but the recent declines combined with the Nasdaq showing signs of life could be an indication investors are willing to be more aggressive and less exposed to utilities stocks.

Even if valuation is not the primary problem with these ETFs, there are technical issues, too. All three have fallen below their 20-day moving averages. Exelon EXC, a top-10 holding in all three ETFs, cut its dividend earlier this year. Last month, Teco Energy TC announced a dividend reduction. Small-cap utility Atlantic Power AT is another member of the utility dividend cut club in 2013.

All of that is not to say other XLU constituents will be reducing dividends, but it is also fair to say utilities ETFs are too pricey to have deal with the specter of lower payouts. Particularly when XLK and QQQ trade at lower valuations and offer ample exposure to cash-rich companies that have helped propel technology to the fastest-growing dividend sector in the U.S.

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