Issues

Call it a quadrennial ritual: In the first weeks after the US presidential election, investors scramble to find the trades that will work best under the incoming administration. Invariably, they forget that US government policies are just one of many factors that can influence corporate earnings and investment returns. Eight years ago, the conventional wisdom assumed that the Obama administration would be toxic for the stock market, especially the health care, financial and energy sectors. With only a few weeks left in Obama’s second term, the S&P 500 is up 210 percent, with the health care and financial sectors outperforming. US oil and gas production also reached new heights under Obama’s watch. Conversely, despite rising adoption of renewable energy, Guggenheim Solar (NYSE: TAN)—an exchange-traded fund that offers one-stop exposure to solar-power stocks—burned up almost 80 percent of its value during Obama’s terms in office. Like Obama in 2009, President-elect Donald Trump will take office with his party in control of Congress, creating the potential for the new administration to deliver on promises to cut taxes, reduce regulation and promote infrastructure investment. The past eight years reinforce that Republicans may not accomplish everything they set out to do.

Buying a stock when others are selling can be just as challenging psychologically as taking a profit on an investment that seems to rally every day. However, these incremental moves can help to juice your portfolio’s returns during periods of volatility. Paying close attention to valuation worked well for us in 2016 and will again in 2017, when we’ll learn the extent to which an expansionary fiscal policy can prolong the bull market and accelerate economic growth. This month’s feature article highlights 10 trends that could drive returns for the more than 200 essential-service stocks in our coverage universe.  

The S&P 500 Utilities Index has tumbled in the wake of the 2016 election, as the conventional wisdom holds that the results were bad for utility stocks. Rising interest rates and the prospect of improved economic growth if the Trump administration delivers on its promised fiscal stimulus have given portfolio managers an excuse to rotate out of utility stocks and into cyclical fare. Unsustainably high valuations made this decision all the easier. Conrad’s Utility Investor subscribers who followed our lead over the summer and took partial profits on their big winners and added exposure to ProShares UltraShort Utilities (NYSE: SDP) should be doing reasonably well, all things considered. This exchange-traded fund, which delivers two times the Dow Jones US Utilities Index’s inverse daily performance, has rallied by about 25 percent—and we see the potential for more upside. However, the most important point to take away from this issue of Conrad’s Utility Investor is that the underlying business conditions for our favorite utilities haven’t changed. The sector remains in excellent financial shape and has its best growth prospects in decades. Unfortunately, valuations remain frothy. Election 2016 has created far more opportunity than risks for best-in-class utilities. But potential regulatory tailwinds are only one of the many factors that will drive returns going forward.  

For just the 18th time since the last World War, the S&P 500 Utilities Index has suffered a pullback of more than 10 percent from its previous high. Excluding dividends, these past swoons have averaged a 23 percent decline over a period of about 14 months. Our base case calls for further weakness in utility stocks, as the risk-reward balance remains skewed to the downside. Over the past several months, we’ve systematically reduced our exposure to names we wouldn’t feel comfortable holding in an economic downturn and taken partial profits on some of our big winners—many of which have pulled back 15 percent to 20 percent since early July. At the same time, our position in ProShares UltraShort Utilities (NYSE: SDP), an exchange-traded fund designed to deliver two times the Dow Jones US Utilities Index’s inverse daily performance, has gained about 18 percent since early July. We’ve also assembled a shopping list with dream prices for our favorite stocks. Although we remain committed to buying and holding high-quality stocks for the long haul, our recent moves have positioned us to profit from whatever lies ahead.  

Utility stocks’ summer swoon picked up steam, with the Dow Jones Utilities Average down more than 9 percent from its high in early July. The financial infotainment industry has blamed this pullback on speculation that the Federal Reserve could raise interest rates this fall. In reality, the run-up in utility stocks to record valuations set the stage for momentum-seeking investors to use any excuse as an opportunity to take profits. Expect to hear a lot more about US monetary policy and its implications for utility stocks if this correction deepens in coming weeks. But bear in mind that weakness in the US economy likely will prevent the Federal Reserve from further tightening this year and that market history reveals scant correlation between utility stocks and the direction of interest rates. Consider that when the Federal Reserve hiked the benchmark interest rate by 425 basis points between June 2004 and June 2006, the Dow Jones Utilities Average generated a total return of more than 60 percent—almost four times the gain posted by the S&P 500. Concerns about rising interest rates may give investors an excuse to sell utility stocks in the near term, but frothy valuations not seen since the 1960s will be the real cause. At these levels, momentum-seeking investors tend to have itchy trigger fingers. Against this backdrop, we continue to err on the side of conservatism and bide our time for utility and telecom valuations to revert to the mean, at which point will look to deploy the dry powder we’ve accumulated by exiting riskier positions and taking partial profits on big winners.

Second-quarter earnings are in for most of the more than 200 essential-service companies in our coverage universe. You can find our analysis of these results in this month’s update to the Utility Report Card. One quarter’s results won’t make or break most companies, but this earnings season was of particular importance for two reasons. By most valuation metrics, utility stocks trade at levels not seen the early 1960s; this earnings season provided a reality check to see if the companies’ underlying fundamentals lived up to the market’s lofty expectations. Growth has also stalled out in some industries and economies this year. The past quarter’s earnings and management teams’ outlooks for the remainder of the year provide an early test of how vulnerable companies could be in a bear market or recession. The vast majority of the names that we cover continue to deliver the goods as businesses, with most meeting or exceeding their guidance. Although some companies earned higher buy targets and we feel more comfortable with some names that had landed in our doghouse, many of the stocks in our Utility Report Card trade at unsustainably high valuations. At these levels, the risk of a pullback remains elevated.

At the midway point of 2016, the utility and telecom sectors have emerged as the top performers in the S&P 500, delivering total returns of more than 20 percent. Given the make-up of our model Portfolios, we’re not complaining. Our Conservative Income Portfolio holdings have rallied an average of about 25 percent this year, while the names on our Top 10 DRIPs list have gained an average of almost 30 percent. The Aggressive Income Portfolio has posted an average total return of about 15 percent, while the spotlighted stocks from each issue have gained an average of 14 percent. Although we remain confident in our holdings’ underlying businesses and growth prospects, stretched valuations suggest that the recent momentum-driven gains won’t last. Historically, the risk of a pullback is elevated whenever the Dow Jones Utilities Average trades at more than 20 times earnings and yields less than 3 percent—a cause for caution. We continue to emphasize the importance of taking advantage of this rally to reduce risk, rebalance your portfolio and take some profits off the table in big winners. This dry powder will come in handy during the inevitable pullback.  

The Dow Jones Utilities Average finished the week at a record high and the index’s price-to-earnings ratio has blown out to levels last seen in early 2008. Although this froth in the market increases the bar of expectations for utility stocks and heightens the risk of a pullback, our favorite utilities enjoy ready access to low-cost capital and ample opportunity to grow their rate base through investments in renewable energy, pipelines and gas-fired power plants. The recent momentum driving utility stocks higher reflects concerns about the US economy and the market’s growing realization that the Federal Reserve will struggle to raise interest rates this year. In this environment, investors gravitate toward utilities’ resilient cash flow and above-average dividend yields. Whereas reliable earnings are enduring features of regulated utilities, the influx of capital driving these stocks to new highs rests on something far more fickle: investor sentiment. When momentum investors find an excuse to take profits off the table, the sector will take a hit, regardless of underlying fundamentals. In this environment, investors should take advantage of the rally to exit riskier names, take some profits off the table in their winners (14 Portfolio holdings trade above our buy targets) and assemble a shopping list of stocks to buy when the inevitable pullback occurs.

We’ve enjoyed the recent rally in equity markets immensely, with our laggards finding their footing and a handful of the names in our Conservative Income Portfolio hitting all-time highs. But stretched valuations increase the risk that results will disappoint the market’s lofty expectations. When investors disregard valuations to pay this much for dividends, the risk of a selloff increases. Meanwhile, first-quarter results from the essential-service companies that we track in our Utility Report Card reveal warning signs that corroborate our concerns about weakness in the US economy. a number of electric and gas utilities reported slumping sales to industrial users. Although utilities generate the preponderance of their cash flow from residential and commercial customers and shouldn’t be troubled by this headwind, weakness in this segment suggests that activity in this part of the economy have continued to slow. Against this backdrop, investors should continue to exercise caution on cyclical businesses and names with excessive leverage. You can also play offense by setting limit orders to buy high-quality utility stocks at dream prices that would only be hit in the event of a significant pullback in the broader market. None of the 214 essential-service companies that we cover announced a dividend cut over the past month. But elevated valuations and potentially slowing growth suggest that investors should consider reaping at least a partial profit on some of the gains earned during the recent rally. Those looking to deploy capital should scrutinize the soil before they sow their seeds.

Morningstar (NSDQ: MORN) recently reported that 247 mutual funds suffered outflows of at least 10 percent over the past year, with 18 losing more than 40 percent of their assets under management. Redemptions on this scale usually occur toward the end of a bear market, when many investors throw in the towel. This hemorrhaging stems from the growing belief that passive investment strategies involving exchange-traded funds (ETF) will outperform an active management over the long haul. Lower fees also help to bolster overall returns. Of course, ETFs and other products that offer one-stop exposure to a particular sector or theme often weight their positions by market capitalization. Utilities Select Sector SPDR (NYSE: XLU), for example, rebalances its holdings quarterly and exhibits a bias toward stocks that have already run up. At last check, NextEra Energy (NYSE: NEE), which trades at a record 21 times trailing earnings, accounted for 9 percent of the ETF’s portfolio. And the instant diversification offered by ETFs mean that you’ll always own the good, the bad and the ugly, which dilutes the best performers’ contribution. But discriminating investors can take advantage of the rise of ETFs.