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Summary Since the September 17th Fed meeting, utilities have gone up by 7% vs. a 2% gain in the S&P 500. Several utility valuation metrics show the group becoming more expensive during this period. If the Fed increases rates at this month’s meeting, the impact on utilities would likely be greater today than it would have been last month. Last September the big question was whether or not the Fed would raise interest rates. In my previous article I discussed what a rate increase would mean to utility stocks. These stocks have been outperformers since the decision to hold rates steady, with the Philadelphia Utility Index (UTY) up 7% over the last month, while the S&P 500 is only up 2%. Chart 1 (click to enlarge) Source: FactSet Even with the outperformance these past few weeks, utilities are still behind the market year-to-date. Chart 2 (click to enlarge) Source: FactSet It appears that utility dividend yields have basically moved in line with the 10-year Treasury yield. Both yields have declined about 20bp since the last Fed meeting, leaving the spread between the two rates essentially flat. Chart 3 (click to enlarge) Source: FactSet So with the spread versus the 10-year Treasury one standard deviation above the average, utilities look cheap relative to Treasuries. This is the same situation we were in one month ago. One could argue that Treasuries aren’t the optimal comparison for utility dividends, so I have also completed an analysis comparing utility dividend yields to BBB corporate bonds with a 7-10 year maturity. These bonds are of lower quality than Treasuries, but still are investment grade. An investor would likely consider these bonds in addition to utility stocks when looking for extra yield. Below is a chart showing how the spread between the yields has moved so far this century. Chart 4 (click to enlarge) Source FactSet It is interesting to see that before the financial crisis corporate BBB bonds were typically yielding a few percentage points more than utility stocks, with the exception during the 2002 to 2003 period when Enron and other issues hit the utility sector hard. Since the financial crisis, utility yields have been trading close to BBB corporates. This seems to imply that investors looking for more yield consider these two investment areas as at least partial substitutes for each other. Looking at the chart starting in 2014 helps give a better feel for what is happening today. Chart 5 (click to enlarge) Source FactSet Utilities hit their peak earlier this year, and that is at about the time when the widest spread versus corporates was reached. Since the last Fed meeting it looks like the spread has widened slightly, making utilities a little more expensive than they were versus BBB corporates. But the change hasn’t really been that great. While utilities look cheap compared to BBB corporates and Treasuries, if you just look at the historic dividend yield of the group things start looking a bit more expensive. Here is a chart showing the historic utility dividend yield since 2000. Chart 6 (click to enlarge) Source: FactSet Zooming into the data since 2014 gives us this chart: Chart 7 (click to enlarge) Source: FactSet You can see that these stocks got really expensive earlier this year and that valuations started coming in leading up to the September Fed meeting. Since then there is a definite trend of the utilities getting more expensive as the dividend yield has decreased. Historic P/E ratios make the utilities look even more expensive. Chart 8 (click to enlarge) Source: FactSet My previous article used data through September 7th, and that was basically the year’s low point for utility P/E ratios. Since then utility P/Es have sharply risen, and as of October 20 are at 16.25x. This is about one standard deviation above the average since the turn of the century. This increase in utility P/Es is likely driven by a response to interest rates rather than to issues specifically related to the utility industry. For example, UTY components Exelon (NYSE: EXC ) and FirstEnergy (NYSE: FE ) should be benefiting from positive trends on the merchant generation front (see an example here ). However, these companies actually lagged the UTY over the last month. With utilities moving in step with interest rates over the last month it seems like the potential negative impact from a rate increase by the Fed is greater than it was in September. Utilities aren’t as expensive as they were in the beginning of 2015, but they have definitely bounced well off of their lows for the year. Conclusion Utility investors who feel the Fed will raise rates at the October meeting may want to think about trimming some positions. Xcel (NYSE: XEL ) and Ameren (NYSE: AEE ) are examples of utilities that have outperformed the UTY over the last month, and would be good potential trimming candidates if you are concerned about the impact of a rate increase. AEE’s outperformance may have extra interest rate sensitivity because of the dividend increase they announced on October 9th. The biggest ETF impacted by these factors would be the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ). Utility valuations aren’t rich enough to say with certainty that a Fed increase will hit the stocks hard, but the risk is definitely greater than it was last September. Scalper1 News
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