There is something REALLY surprising happening in the market right now. While everyone focuses on inflation, $100 oil, Russian nuclear threats, surging natural gas prices, and the threat of a recession, utility stocks are soaring.
This rally is an unusual event for any market. Utilities are typically seen as safer investments with defensive attributes and reliable dividends. But a funny thing happened on the way to April. Over the last month, utilities have been the second-best performing sector among the 11 S&P components.
How and why did this happen? And what does it mean for investors moving forward?
Economic Protection in Utility Stocks
While the odds of a recession might be low in 2022, the data shows Americans are worried. According to CNBC, 81% of Americans worry about a recession coming. This is important.
When you think a recession is coming, you start to cut back. If enough Americans cut back due to the economic threat, the bigger threat can and will become economic reality. Investors who worry about a recession appear to have piled in on utilities in a major way. The Utilities Select Sector SPDR Fund (XLU) has popped nearly 10% in less than a month.
The XLU – now at a 52-week high – contains large utility giants. These include: NextEra Energy (NEE), Duke Energy (DUK), Southern Company (SO), Dominion Energy (D), Exelon Corp (EXC), and American Electric Power (AEP).
These companies all pay strong dividends, which are sought by defensive investors. The companies provide power to homes, small businesses, and industries. They also create a product that is effectively immune from most economic downturns.
Relying on Inelastic Demand
Electricity is a “must have” product with largely inelastic demand. Meaning people will pay a higher price while demand remains strong. Now, it’s not like these companies can just spike energy prices at will to boost profits.
For the bulk of the sector, state utility commissions allow these companies to generate a set return over the cost of generating electricity and their total costs of capital.
But if they do experience “inflationary” pressures, they will receive permission to increase their rates. Tack on higher input costs in natural gas and coal, and these higher prices will be passed onto their customers and reflect higher revenue and profits on the balance sheet.
It seems investors have already made their move. But don’t take it as a surprise if in the short term some profit taking comes and we get a pullback in the XLU. This is a very good environment to start selling cash-secured puts on the utility stocks that you’d want to buy at lower prices (and thus higher dividends).
Update on Momentum
Finally, heading into next week, momentum remains red, and weakness is persistent across the market. This morning, we saw a small pop in stocks. After, there by a quick downturn in the technology and consumer cyclical sectors.
I know it may be hard to resist temptation and load up on some technology companies for the long-term, but I still urge caution. Volumes remain low, and small bull traps (as I discussed yesterday) are common and easy to create when algos make a series of fast, furious purchases.
Negative momentum appears to be the trend with higher volatility in the coming days. I don’t expect investors to pile back into stocks with much volume pressure until we kick off earnings season.
And even then, expect many institutions to be VERY selective with how they allocate their capital in the months ahead. Remember, cash is your best friend right now.