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Why you should avoid utilities in a rising rate environment

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And within a larger equity allocation, here are three more specific ideas to consider.

1. Lessen exposure to bond market proxies like utility companies. These segments have historically responded poorly to rising real rates. For instance, when real rates rise, the relative valuation of utility companies, as measured by sector’s price-to-earnings ratio relative to the broader market, compresses as investors become less willing to pay up for each dollar of earnings. This suggests that if utility valuations are high, as they are today, the sector could underperform in a rising rate environment.

utilities

Market Realist – The graph above shows how the utilities (FXU) sector, as tracked by the iShares Dow Jones U.S. Utilities Index Fund (IDU), has been climbing steadily.

utility sector valuations

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Market Realist – The above graph from BlackRock shows how utility global valuations are at the upper end of their historical range. The sector is widely considered to be overvalued compared to broader market indices like the S&P 500 (SPY)(IVV), the Dow Jones Industrial Average (DIA), and the tech-heavy NASDAQ (QQQ).

According to S&P Capital IQ estimates, utility ETFs like the Utilities Select Sector SPDR (XLU), Vanguard Utilities ETF (VPU), and iShares U.S. Utilities (IDU) have a negative “fair value” rating. This essentially means their prices are more than analysts’ fair-value estimates.

Read on to the next part of this series to learn how the U.S. technology sector can bode well for investors in a rising rate environment.

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