Utilities Slump Could Be Nearing Its End

The Utilities Select Sector SPDR XLU, the largest utilities exchange-traded fund by assets, last year rose 12 percent. That sounds okay until measuring the utilities sector against the broader market. By the time 2017 came to a close, XLU lagged the S&P 500 by 970 basis points.

XLU's struggles and those of the utilities sector in general are continuing in 2018. After the Federal Reserve boosted interest rates three times last year, rarely good news for the rate-sensitive utilities sector, many market observers were betting on more rate hikes heading into 2018. Year-to-date, the benchmark utilities ETF is off almost 8 percent and resides more than 15 percent below its 52-week high.

That puts XLU well into correction territory and dangerously close to meeting the definition of a bear market, which is a 20 percent decline. Add to that, the defensive utilities sector hasn't held up well as U.S. equities have tumbled in February. XLU is lower by more than 4 percent this month. Still, some analysts believe the sector is poised to bounce back.

Some Value

Due to the sector's defensive traits and often tempting dividend yields, utilities often trade at premiums to the broader market. Some data points suggest the sector's value prospects are currently reasonable.

“On a median basis, U.S. utilities now trade in line with our fair value estimates, the cheapest they’ve been since 2015,” said Morningstar in a recent note. “This is a sharp reversal since Nov. 14, when utilities reached a peak 1.18 price/fair value ratio. Since then, the Morningstar US Utilities Index is down 14 percent and has underperformed the S&P 500 by 19 percentage points. No other sector has performed as poorly.”

The $7.14 billion XLU, which tracks the Utilities Select Sector Index, holds 28 stocks and has a dividend yield of almost 3.7 percent. Spreads between 10-year Treasuries and the utilities sector's dividend yield are historically tight right now.

Fundamental Risk

There are some fundamental issues to consider with utilities stocks and ETFs.

“Utilities’ key fundamental risk is a potential cut in regulated returns, which would reduce our earnings growth outlook,” said Morningstar. “However, regulators have been slow to pull back allowed returns in a persistent low-interest-rate environment. Rising interest rates and tax cuts will take some pressure off regulators to cut utilities’ allowed returns.”

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