Investors recently got a brief glimpse of what the future may hold for Utility stocks in a rising rate environment where growth prospects are muted. The view wasn’t pretty.

A positive data point on job creation came out earlier this month and interest rates jumped as bonds sold off. Domestic equities took the news in stride, ending the day down modestly. Utilities, however, fared much worse. The group, as represented by the Utilities Select SPDR Exchange Traded Fund (XLU), was off more than 4%.*

The sell-off was a cautionary reminder of just how stretched valuations have become for the sector.

For the past several years, money has poured into Utilities in a scramble to replace income previously generated from debt securities. With Federal Reserve policy focused on keeping rates low, income hungry market participants have turned to bond proxies such as Utility stocks.

As the chart below illustrates, performance of power producers is typically inversely related to the yield on the 10-year Treasury. When Treasury yields go down, the sector goes up.

 

The magnitude of the chase for income has warped valuations for Utility stocks to levels we believe are hard to justify given tepid growth prospects for the industry and the current state of interest rates.

The group faces headwinds on several fronts:

  • The emphasis on energy efficiency has begun to leave a mark on electric consumption. Everything from the adoption of LED lights to replace incandescent bulbs, to more energy efficient appliances introduced to meet Federal guidelines, have combined to reduce growth demand.
  • Consumers are reducing traditional power consumption by installing solar panels on their homes.
  • Similarly, the U.S. economy is less reliant on power-intensive manufacturing.

The upshot is that while the S&P SmallCap 600 Multi-Utilities group is trading at nearly 20x forward 1-year price-to-earnings, which should imply decent future earnings growth, we believe actual prospects for increasing sales are lackluster.

Treasury yields also seem unlikely to be constructive for the sector in the long run. With the 10-year Treasury trading with a yield in the 2% range, it is reasonable to expect investors will see higher yields in the future. When those increased rates materialize, power companies will lose the primary reason they have been so attractive during the past five years. As a result, investors are likely to see Utility stocks falter more severely than is typical for the stodgy dividend stalwarts.

Disclosure:

 

*As of 2/6/2015

 

Past performance does not guarantee future results.

 

As of 12/31/2014, Heartland Advisors on behalf of its clients did not hold Utilities Select SPDR ETF. Portfolio holdings are subject to change. Current and future holdings are subject to risk.

The statements and opinions expressed in this article are those of the author. Certain security valuations and forward estimates are based on Heartland Advisors’ calculations. Any forecasts may not prove to be true. Statements regarding securities are not recommendations to buy or sell the securities discussed. Such statements represent the author’s view when made and are subject to change at any time based on market and other considerations. Economic predictions are based on estimates and subject to change.

Sector classifications are generally determined by referencing the Global Industry Classification Standard Codes (GICS) developed by Standard & Poor’s and Morgan Stanley Capital International.

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