Koesterich Cautious on Utilities (XLU, IDU)

Thanks to ample global macroeconomic headwinds and elevated broader market volatility, investors have sought shelter with a familiar sector in 2012: Utilities. Looking solely at performance, normally slow-moving utilities ETFs have impressed in recent months as the Utilities Select Sector SPDR XLU and the Vanguard Utilities ETF VPU have both returned more than five percent. The iShares Dow Jones U.S. Utilities Sector Index Fund IDU is not far behind with a gain of 4.9 percent. Those returns may indicate the easy money in utilities has already been made and that investors should approach this sector, prized for its low beta ways, with caution. In a recent blog post, iShares Global Chief Investment Strategist Russ Koesterich says "...some segments of the market – such as US utilities — are looking expensive and should likely be avoided." Koesterich has a point regarding the valuations for utilities, which have previously been highlighted as rich. On June 18, XLU sported a price/earnings ratio of 15.4, which was towards the higher end of the historical average for high-quality utilities stocks. That is roughly what XLU's current forward P/E is today and the fund's weighted average P/E for reported earnings is close to 16.2. The P/E ratio for the iShares Dow Jones U.S. Utilities Sector Index Fund based on the latest 12 months worth of earnings is even more elevated at close to 19, according to iShares data. "Investors have pushed US utility stocks up too far as US utilities currently look even more expensive than they were back in January. US Utilities are currently trading at nearly 15x earnings, versus an average since 1995 of around 14.5x," Koesterich said in the blog post. "And the stocks are even more expensive when you compare their valuation to the broader market. As a regulated industry, utilities typically trade at a discount to the broader market. Since 1995, US utilities have traded at an average discount of roughly 25% to the S&P 500. Today, however, US utilities are currently trading at a more than 8% premium, the largest since late 2007." Koesterich notes the premium "can't be justified" because utilities are not as profitable as some investors perceive the sector to be. Rather, "return on earnings for US large cap utility companies is currently 10.5%, the lowest level since 2004," he said. Translation: Utilities stocks and ETFs have benefited from investors flocking to sectors sporting above-average yields. XLU and IDU do deliver on that front with 30-day SEC yields of about 3.5 percent each. One of the yield alternatives to utilities highlighted by Koesterich was the iShares High Dividend Equity Fund HDV. HDV has gained 3.3 percent in the past month, outperforming IDU and XLU along the way. Plus, HDV has a 30-day SEC yield of 3.6 percent. Investors willing to take on sector risk might consider the iShares S&P Global Telecommunications Sector Index Fund IXP, Koesterich said. IXP is up almost three percent in the past month while its U.S.-focused equivalent, the iShares Dow Jones U.S. Telecommunications Sector Index Fund IYZ has added nearly two percent. The 30-day SEC yields on the two ETFs are 4.4 percent and 3.3 percent, respectively.