Why Utilities Could Keep Smashing in the Fourth Quarter

Despite valuation concerns, utility stocks seem relatively well placed at the moment compared to broader markets. October is the most volatile month for the markets historically, and we had a glimpse of this in the last few days. Importantly, overall market sentiment looks gloomy, which might favor utilities.

So far, the Utilities Select Sector SPDR ETF (XLU), the representative of top utilities, has surged more than 20% this year. In comparison, the S&P 500 rose by 15%. The US manufacturing PMI (Purchasing Managers’ Indexes) contracted to a decade-low level of 47.8 in September. This raised recession fears. Readings below 50 suggest contraction and readings above 50 points to expansion.

According to Bloomberg’s article on October 2, the IMF (International Monetary Fund) expects a significant global slowdown. It didn’t expect this three months ago, said First Deputy Managing Director David Lipton. The IMF has lowered its global growth outlook four times in the last 12 months. This is mainly due to trade uncertainties. Thus, utilities could continue to look strong given all the gloomy signals for the future.

Southern Company (SO), the top rallied utility stock of the year, has surged more than 42% in 2019. It has been trading near all-time highs in the last several months. Also, renewables titan NextEra Energy (NEE) stock gained more than 32% so far this year.

Lately, President Trump has been vocal about criticizing the Fed. He insists that it lower interest rates further. Lower interest rates could boost utility stocks. However, the Fed has already lowered rates by quarter-points twice this year. Utility stocks and interest rates typically move inversely to each other. The Fed may lower rates further to boost economic growth.

Lower rates make utilities’ yield look more attractive compared to bonds. At the same time, lower interest rates make debt servicing costs lower. Ultimately, this could boost a company’s profitability.

Utilities generally pay a large portion of their earnings to their shareholders in the form of dividends. That’s why they have relatively higher dividend yields. The Utilities Select Sector SPDR ETF (XLU) offers a yield of 3% while Southern Company and NextEra Energy yield 4% and 2.3%, respectively.

Notably, Southern Company is one of the top-yielding stocks. In contrast, NextEra’s yield is the lowest. Broader utilities grew their dividends by around 5% per year in the last few years. Also, they plan to maintain similar growth in the future.

Investors typically shift to relatively safer utilities amid broader market uncertainties. They have very little or no correlation with economic cycles. Also, US utilities look stable from the earnings perspective. This is because of their domestic operations, and they have no exposure to trade tensions.

Utility stocks continue to trade at record valuations at the moment. They are trading close to 19 times their forward earnings, close to that of the broad market index S&P 500. These defensives generally grow slowly compared to broader markets. Thus, paying a similar multiple for these slow-growing defensives looks unwarranted.

Top rallied stocks Southern Company and NextEra Energy are trading 20 times and 26 times their forward earnings, respectively. Both these stocks look to be trading at a significant premium against their respective historical averages.

Dominion Energy (D) is the fourth largest utility by market cap. The company is trading 18 times its estimated earnings. The company looks relatively better placed from the valuation perspective. However, Dominion Energy stock has rallied just 12% this year, underperforming peers.

With recession fears growing, picking stocks to hedge for uncertain times could be tricky. The PG&E’s (PCG) “Camp Fire” was a disaster that killed 86 people. So, it looks like an ETF could be a relatively safe option instead of an individual utility. One of the biggest power companies, California-based PG&E filed for bankruptcy in January on wildfire-related liabilities.

The Utilities ETF (XLU) has not just acted as a hedge in the short term. Also, it has outperformed the S&P 500 in the long term. It returned, including dividends, almost 80%. In contrast, the S&P 500 returned 62%. The Utilities Select Sector SPDR ETF (XLU) holds 30 top utility stocks. It has an expense ratio of 0.13%. iShares US Utilities ETF (IDU) has 48 constituents. Also, it has an expense ratio of 0.43%.

Wall Street analysts expect flat to the negative potential upside from the top utility stocks for the next 12 months. The unusual rally so far this year suggests these stocks might slow down a little. However, broader market volatility could continue to push yield-seeking investors towards these defensives.