Is Sector Rotation Pointing to Utility Stocks?

The stock market has often been likened to a vast, constantly shifting sea. For investors aiming to maximize returns and manage risks, understanding its ebbs and flows is essential. One effective way to navigate this vast sea is to grasp the principle of sector rotation and its relationship with economic cycles. This principle suggests that at various stages of the economic cycle, different sectors will outperform or underperform the broader market. Right now, there’s a compelling argument to be made for utility stocks. Let's delve into the reasons.

1. Understanding Sector Rotation and Economic Cycles

Sector rotation refers to the cyclically driven shifts in stock market leadership, where investors transition their portfolios among sectors based on the current economic cycle. These stages include early expansion, full expansion, early contraction, and full contraction. Each stage has sectors that traditionally perform best:

Early Expansion: Typically favors cyclicals and transports.

Full Expansion: Sees technology and industrials outshine.

Early Contraction: Prefers non-cyclicals, like utilities.

Full Contraction: Usually finds comfort in staples and healthcare.

The economic cycle, meanwhile, is an undulating pattern of economic expansions (growth) and contractions (recessions). Aligning these two cycles and forecasting future economic activity is the real challenge. Ultimately, it all boils down to how you have interpreted the data provided to you. 

2. Why Utility Stocks?

Utility companies are providers of essential services—think electricity, water, and natural gas. These are services we all need, and most likely will not be cutting back on. They also provide a few very attractive benefits:

Defense: As they say in football, Defense wins championships. While there isn’t really a championship in trading or investing, we are striving to grow and protect our accounts in all market phases. Utilities are often considered defensive stocks. This means that even during economic downturns, the demand for utilities remains relatively consistent. After all, regardless of the economy's status, people still need power, water, and gas. As a result, utility stocks typically provide a stable dividend and tend to be less volatile.

Dividends: Utility firms often pay out substantial dividends, making them appealing for income-focused investors, especially during uncertain economic times when safe returns are hard to come by. Utility companies like Algonquin Power & Utilities Corp. (AQN), New Fortress Energy Inc. (NFE), Kenon Holdings (KEN) and many others offer over 7% annual dividends.

Regulation and Monopoly: Many utility companies operate in a regulated environment, which can mean stable revenues and predictable earnings. While regulation can limit the upside during boom periods, it also offers protection during downturns.

3. The Current Economic Landscape and Utilities

If we observe the current economic conditions and match them to our sector rotation models, there are signs we are transitioning from full expansion to early contraction. With rising interest rates, inflationary concerns, and other macroeconomic indicators signaling a potential slowdown, defensive sectors like utilities usually come into favor. Looking at the chart of the S&P500 ($SPX), I think it’s safe to say that we are past the Full Expansion phase where tech and industrials led. This current contraction would historically benefit utility stocks.

When economic growth starts to decelerate, investors often look for safer places to park their money. The consistent demand for utilities and the attractive dividend yields they offer can provide the safety net investors seek.

4. The Rub - Rising Interest Rates

One traditional challenge for utility stocks is the environment of rising interest rates. Since utilities are capital-intensive and often carry significant debt, rising interest rates can increase borrowing costs. However, if rates rise due to concerns about inflation rather than booming economic growth, utilities might still be the preferred choice because of their defensive nature and dividend payouts, which can help hedge against inflation.

While there are many different utility stocks to choose from, I’m lazy when it comes to doing deep fundamental analysis. Some of you thrive on this and may pick individual stocks which offer the best potential rate of return. For me, I’m going with the dominant utility ETF, the S&P Utilities Sector SPDR (XLU). It is comprised of 33 different utility companies representing a broad range of services, which helps diversify risk. From a technical perspective, XLU has been getting destroyed over the past year. 

While Barchart Technical Opinion is a STRONG SELL, I’m looking to catch this falling knife. It is currently down over 27% off its September 2022 highs, and down a gut wrenching 13.46% in the past 13 trading sessions. Yet it has fallen right into a demand zone around $55. I sold Puts on Monday October 2nd at the strike price of $54. A price I’d be happy to own XLU. For this, I collected 1.1% worth of premium for 21 days. XLU also pays a 3.34% yield. 

Understanding the nuances of sector rotation models and their relationship with economic cycles can give investors a significant edge. While no strategy guarantees success and past performance isn't indicative of future results, the economic indicators seem to be aligning in favor of utility stocks, with one big exception, Interest rates. Many investors who typically look to utilities for safety and yield can currently buy 3-month treasuries yielding roughly 5.5%, risk free. Despite this, I’ll take a chance on XLU at $54. 

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On the date of publication, Merlin Rothfeld had a position in: XLU. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.