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What Stretched Utility Sector Valuation Means

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I continue to hold an underweight view of US utilities for two reasons:

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1.) The Utility Sector Valuation:

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 above 18x earnings, versus an average since 1995 of around 14.8x. 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 (SPY)(IVV). Today, however, US utilities are currently trading at a more than 1% premium.

Utility Sector Valuation is looking rich

Market Realist – Utility sector valuation appears stretched

The graph above shows the trailing 12 months (or TTM) PE ratio (price-to-earnings ratio) for the S&P utilities sector for the last 20 years, along with the 20-year average. The current ratio of 18.3x is well above the 20-year average for the sector, which is 14.8x. This means that the utility sector valuation is stretched.

2014 was a great year for utilities, which gained 26.62% ex-dividends and were the best-performing sector. The utilities sector was the best-performing sector in 2011 as well, with gains of 14.25%. However, it was the worst-performing sector in the following year, with negative returns of 4.2%.

Also, with the US economy improving, cyclical sectors like technology (QQQ) and financials (XLF) could outperform defensives like utilities (XLU).

However, the fact that the sector is trading above its long-term average alone is not a valid reason to avoid a particular sector. The next part of this series focuses on why the utilities sector could underperform.

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