A Neutral View On A Big Utilities ETF

Last year represented a tale of two views for utilities stocks and exchange-traded funds. ETFs such as the Utilities SPDR (ETF) XLU burst out of the gates early in the year as investors favored defensive, low volatility, high dividend sectors.

By virtue of its bond-like characteristics but hearty yield, XLU is a favorite among defensive-minded, yield-starved income investors. Unfortunately, persistently high valuations are suppressing utilities sector, potentially making the sector even more unattractive as investors price in multiple interest rate hikes from the Federal Reserve this year.

While XLU did slide in anticipation of the Federal Reserve raising interest rates in December, which came to fruition, the largest utilities ETF is higher by more than five percent over the past month. It also pays to remember that many of the market observers that said the Fed raise rates multiple times in 2015 and 2016 were proven wrong as just one rate hike was unveiled in each of the past two years.

Utilities And Analyst Commentary

Still, not all analysts are overwhelmed by the utilities sector's prospect. For example, AltaVista Research has a neutral rating on XLU, a rating that reflects average appreciation, according to the research firm.

The neutral rating on XLE “indicates that valuations adequately reflect the fundamentals of stocks in these funds. The majority of funds we cover fall into this category,” said AltaVista.

A common criticism of the utilities sector is that it forces investors to pay up on valuation to garner the benefits of high dividend yields and defensive traits. However, that is not necessarily the case at the moment as AltaVista estimates a 2017 price-to-earnings ratio of 17.1 for XLU, the same estimate the research firm has on the S&P 500.

Catalysts

The potential for easing environmental regulations could be a catalyst for XLU and rival utilities ETFs this year, but it remains to be seen whether investors will depart cyclical sectors for more defensive strategies.

“Although some environmental regulations might be eased in a Trump administration, Utilities is one of only two sectors (the other is Staples) down since the election, as investors shift their focus more towards growth and less in search of yields. Longer term we think distributed generation remains a big threat to Utilities' profitability — witness the declining trend in ROE since 2011,” said AltaVista.