Utilities stocks have experienced an extraordinary rally throughout 2024, becoming one of Wall Street’s most talked-about trades of the year.
But with valuations soaring and economic indicators shifting, some financial professionals are cautioning that the surge might have gone too far too fast.
The Utilities Select Sector SPDR ETF (XLU), which tracks the sector, has pulled back nearly 2.5% from its October 2nd high of $81.47 per share, according to FactSet data.
Even with this decline, the ETF remains up 24.4% year-to-date, outpacing the S&P 500’s 21.4% gain.
Should the ETF end the year above current levels, it would mark the utilities sector’s best annual performance in over two decades.
But as interest rates climb and investor sentiment shifts, some experts believe a correction could be imminent.
Interest rate shifts threaten utilities stocks rally
One of the primary drivers behind utilities’ recent retreat is the changing outlook for US interest rates.
Following a string of strong economic data, investor confidence in the economy has grown, but so have concerns about persistent inflation.
This, in turn, has pushed Treasury yields higher, which negatively impacts utilities stocks, traditionally seen as defensive, interest rate-sensitive plays.
According to George Cipolloni, portfolio manager at Penn Mutual Asset Management, the sharp drop in interest rates earlier this year fuelled much of the sector’s rally.
But as yields reverse course, utilities are losing some of that momentum. Highlighting how bond yields inversely affect stock prices in the sector, Cipolloni said in a MarketWatch report,
How much of the gains in utilities can we attribute to the interest-rate move? I think a decent amount.
Stretched valuations: a warning sign?
Another factor contributing to the pullback in utilities stocks is stretched valuations.
In late 2023, utilities were trading at depressed levels, but the 2024 rally has pushed valuations into overvalued territory.
Travis Miller, an energy and utilities strategist at Morningstar, noted that the sector no longer offers the bargain it once did.
“Given the rally, our team thinks the sector is fairly valued right now,” Miller told MarketWatch.
He cited Vistra Corp. as a prime example of the utilities boom.
The independent power company’s stock has skyrocketed over 200% this year, even outpacing tech giants like Nvidia.
However, Vistra’s current valuation is more than 90 times its earnings over the past year, raising concerns about whether these gains are sustainable.
Deals like Constellation Energy’s partnership with Microsoft to restart a nuclear reactor at Pennsylvania’s Three Mile Island have stoked investor interest.
However, Miller cautioned that the benefits of such deals will take years to materialize, and the market may have overestimated their immediate impact.
“I think those stocks have run up way too quickly, and way too much enthusiasm has been priced in.”
Technical analysts see troubling signs
Beyond fundamental concerns, technical analysts see troubling signs in the charts for utilities stocks.
Jonathan Krinsky, chief technical strategist at BTIG, warned in a report that the XLU ETF is trading at its largest premium to its 200-day moving average since 2003, a signal that a correction of 7% to 10% may be on the horizon.
Jason Goepfert, a senior research analyst at Sentimentrader, also noted that utilities stocks have a history of underperforming when they climb too far above their 200-day moving average, making the sector vulnerable to pullbacks.
As Treasury yields continue to rise, utilities—which typically struggle in such environments—could see more downward pressure.
Cautious optimism for long-term investors
Not all analysts are predicting doom and gloom for utilities. Nicholas Colas, co-founder of DataTrek, maintains a cautiously optimistic outlook.
While he acknowledged that utilities may not be the best performers over the next 12 months, he expects the sector to recover once bond yields start to decline again as the Federal Reserve continues its interest rate cuts.
“The utilities sector should continue to outperform once bond yields head lower,” Colas said, adding that the AI-driven demand for utilities may also fuel future gains.
Lori Calvasina, head of US equity strategy at RBC Capital Markets, shared a more tempered view, noting a slowdown in money flowing into utilities-focused funds.
She speculated that the rush to profit from lower interest rates has already run its course, and utilities no longer offer the same value for investors.
“Utilities are no longer compelling on a valuation basis,” Calvasina said.
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