Momentum, MLPs and Mergers

The May 2016 issue of Conrad’s Utility Investor flagged utility stocks’ stretched valuations as a warning sign that the aging bull market could be winding down. (See Reap before You Sow and Stay Focused.)

A month later, the Dow Jones Utilities Average has climbed to price-to-earnings and price-to-sales multiples last seen in early 2008. Of course, markets can remain irrational much longer than investors can remain solvent; a historically elevated valuation doesn’t necessarily guarantee further downside.

However, consider the price action in Utilities Select Sector SPDR (NYSE: XLU), a popular exchange-traded fund (ETF) that holds shares of 30 prominent electric and gas utilities.

(Click graph to enlarge.)

This price graph largely mirrors the broader equity market, with its general upward trend and sharp retrenchments in 2001-02 and 2008-09.

For investors in utility stocks, the first of these selloffs was more harrowing because of sector-specific problems—namely, excessive leverage and a complete meltdown in the unregulated generation and energy marketing businesses in the wake of Enron’s implosion.

The financial crisis and Great Recession that devastated equities of all stripes in late 2008 and early 2009 didn’t have an outsized effect on most utilities’ underlying businesses and cash flow. Although the relentless selling pressure sparked widespread panic, those who stuck with their convictions and focused on fundamentals were able to lock in high yields on quality utility stocks.

Regardless of the underlying causes, each of these major selloffs coincided with utility stocks reaching historically high valuations. And investors who chased these stocks at the top needed considerable time to be made whole.

Prudent investors who took some money off the table when valuations reached elevated levels turned paper gains into real profits and had the dry powder to take advantage of subsequent pullbacks.

Check out this month’s Portfolio article for the latest update on our three-part strategy for an aging bull market: exiting riskier fare, taking some profits off the table in our big winners and assembling a shopping list of names to buy on a pullback. (See Aging Bull.)