Down, But Still Expensive

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.

Most utility stocks pay a dividend, but they aren’t fixed-income securities; they can growth their payouts over time, and their performance tends to track earnings and economic conditions.

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.