One perennial truth of the financial markets is that rotators will rotate. This year, utilities stocks were out of favor until investors suddenly flipped the switch to the “on” position in recent months. Thus, some investors may be wondering if they should be charged up about about this usually un-electrifying sector.
There may indeed be good values in the utilities sector if you know where to look. More importantly, investors should understand why utilities stocks may be worth owning and what the risks are before jumping into the trade.
Why are investors buzzing about utilities stocks?
Let’s be perfectly honest. Most of the time, investors on social media aren’t busy chattering about utilities stocks. For decades, these stocks have been popular among retirees and other defensive-sector investors because they’re not usually volatile.
Furthermore, utilities stocks tend to offer enticing yields. Here’s a quick sampling of some popular utilities picks and their forward annual dividend yields as of May 11, courtesy of Yahoo! Finance:
- Dominion Energy (NYSE:D): 5.03%
- Duke Energy (NYSE:DUK): 3.99%
- American Electric Power (NASDAQ:AEP): 3.84%
- The Southern Company (NYSE:SO): 3.69%
- NextEra Energy (NYSE:NEE): 2.79%
Undoubtedly, these yields would have been highly appealing to passive-income investors when U.S. Treasury yields hovered slightly above 1%. However, as you surely have noticed, the bond-market landscape has changed dramatically during the past few years.
In October, the annual yield for the 10-year U.S. Treasury bond topped out at almost exactly 5%. Hence, it didn’t make much sense for retirees and other safety seekers to hold utilities stocks with yields of 3% to 5% when they could instead hold Treasury bonds with a 5% yield and zero risk.
Now, the 10-year U.S. Treasury bond yield is around 4.5%, which is still quite competitive when compared to the yields of utilities stocks. However, the market expects the Federal Reserve to lower interest rates sooner or later in order to avert a full-on recession. Additionally, the government can’t easily afford to pay a high rate of interest on federal debt for an extended period.
In anticipation of eventual interest-rate cuts, forward-looking traders now are buying up utilities stocks. I also suspect that some investors are desperately seeking value plays because they missed out on the sharp rally in the Magnificent Seven technology stocks.
There’s also the artificial intelligence (AI) angle. Since practically every other AI angle has already been exhausted, some traders are now turning their attention to utilities stocks. After all, the data centers that power AI applications will require vast quantities of electrical input.
Finally, there’s just good, old-fashioned market rotation going on. To quote Truist Co-Chief Investment Officer (co-CIO) Keith Lerner, investors “want to rotate into something a little more defensive, take some profit[s].”
Lerner also figures that nervous investors are asking themselves, “‘Hey, what hasn’t worked and what could have an opportunity to do some catching up or hold up better should the market correct?'”
What’s the best way to invest in utilities stocks?
Even though they’re up in the short term, American utilities stocks are certainly not in a bubble, especially when compared to high-flying tech stocks.
Furthermore, a quick review of some well-known utilities companies’ trailing 12-month price-to-earnings (P/E) ratios suggests that they’re not too richly valued:
- Dominion Energy: 22.97
- Duke Energy: 18.37
- American Electric Power: 17.06
- The Southern Company: 20.24
- NextEra Energy: 20.16
Those P/E ratios don’t seem objectionable, and they’re certainly lower than what you’ll typically find with a Magnificent Seven company. On the other hand, utilities stocks may be vulnerable to a short-term pullback after their recent rally.
Again, it’s crucial to consider why you might want to own them in the first place. If you’re only seeking high yield without risk, you might just want to lock in a 4.5% interest rate with a government bond.
However, if you’re on board with the long-term narrative that AI will need plenty of electric power — and you’re not convinced that the market has already figured this out and priced it into utilities stocks — then you could start out with a small investment.
You could research individual utilities companies if you have the time and the inclination to do so. However, the simplest and most time-efficient strategy for most retail investors would be to buy a few shares of the Utilities Select Sector SPDR Fund (NYSEARCA:XLU).
It’s an exchange-traded fund (ETF) that holds a broad array of utilities stocks, including the ones I already mentioned. Just don’t go overboard with your utilities-sector investment, as the market’s rotators can flip the switch in the other direction at any given moment.
Disclaimer: All investments involve risk. In no way should this article be taken as investment advice or constitute responsibility for investment gains or losses. The information in this report should not be relied upon for investment decisions. All investors must conduct their own due diligence and consult their own investment advisors in making trading decisions.
