XLU: Not Likely To Be A Safe Haven In A Troubled Market

seekingalpha08-21

Arctic-Images With the market once again pushing towards its all-time high despite worrisome news about massive white-collar layoffs at companies like Intel (INTC), General Motors (GM) and Cisco (CSCO...

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Some are turning towards so-called \"Value\" stocks, though true value is very hard to find in this market and value traps abound. Others, including myself, are considering investing in the Utility Sector by buying into the ETF most often cited as a proxy for that sector: The Utilities Select Sector SPDR Fund ETF (NYSEARCA:XLU). Utilities used to be seen as the safest of safe stock investments - the so-called \"Widows and Orphans\" stocks that brokers could safely invest in for those who could not afford to lose money on their investments. Many still believe this to be true, thinking that even in the direst downturns people will have to keep paying the bills that keep the lights and water on long after they have given up their Netflix subscriptions, newest iPhones, and $6 coffees. Backtesting supports the idea that utilities are a fine investment for hard time. the Utilities Select SPDR Fund ETF, XLU, did outperform the S&P 500 from the end of the Dot Com collapse in December 2002 until the early months of 2013. XLU's Price Outperformed the S&P 500 during the \"Lost Decade\" Seeking Alpha Note that the outperformance depicted in the chart above is price outperformance. When we compare XLU's total return during the so-called \"lost decade\" the results are even more dramatic. In the chart below, I use the Vanguard 500 Index Fund Admiral Shares (VFIAX), an investible version of the S&P 500, to get an accurate idea of the real total return that the S&P 500 could have produced during this period. XLU'S Total Return Compared to VFIAX's \"Lost Decade\" Seeking Alpha Investors who believe that the S&P 500 is headed for another prolonged period of disappointing returns might find the idea of taking refuge in XLU very tempting based on this extended past performance advantage. Even when we go back to XLU's inception in December 1998, during the most exuberant years of the Dot.com frenzy, we find that XLU's long-term outperformance compared to the S&P 500 persisted until the end of January 2013 when the S&P 500 finally began its next raging bull market. The chart below shows its price performance from the height of the Dot.com frenzy to the end of the \"lost decade\". Its total return was even more dramatic than the price return shown below, given the higher dividends paid by utility stocks. XLU's Price Outperformance, Dec 1998-Jan 2013 Seeking Alpha Is XLU Capable of Repeating Its Past Success in Tough Times? What I want to do in the rest of this article is examine whether investors can expect to see similar outperformance from XLU should the market as a whole, which is again close to its all-time high and sports a very high P/E ratio, experience another prolonged decline. XLU is Coming Back Into Favor With Investors After a Hiatus XLU's price has been surging since February 2024. That's probably because that was when investors began to believe that the Federal Reserve would have to raise its rates this year. Until then, XLU had lost much of its appeal to income investors for several reasons. Declining Treasury Rates Make XLU's Yield More Attractive The first reason for investors turning away from XLU was its dividend yield., which typically fluctuates around 3%, stopped being competitive with the 5% yields available in far safer Treasury bills, notes, and bank CDs. But as investors sold off their utilities its price fell, causing XLU's yield to rise, until, at its peak in October 2023, it reached a high of 3.77%. XLU Dividend Yield History Past 12 Months Seeking Alpha XLU's higher dividend began to attract some investors, though the surge in investment dollars into XLU really only took off in the middle of April 2024 when more investors began to believe that the Federal Reserve would soon cut their rate soon. That would make XLU's yield far more competitive with Treasuries, even though XLU's rising price was causing its yield to drop below its usual 3% range. Then a few months later, as Treasury rates began to decline in response to investors' expectations of oncoming cuts, in June, money began a steady flow back into XLU as you can see from the chart below. VettaFi This Surge in Investor Interest in XLU Has Pushed Up Its Price and P/E Ratio and Reducing Yield The earnings of XLU's holdings don't increase very fast. So the rise in XLU's price has caused the ETF's current P/E ratio of to rise to 20.67. This is a very rich valuation for the stocks of companies whose payouts to investors are regulated by states and only likely increase modestly because of this tight regulation. State Street Global Advisors, XLU's fund provider, tells us that XLU's forecasted 1 year P/E ratio is expected to be lower at 18.50, but this is still high enough to suggest that the Utilities in XLU do not currently represent excellent values. The decline in treasuries is still not a potent force to drive investors to XLU at its current price and yield. Its current 2.93% yield doesn't compare well with the yield of the far more diversified Schwab U.S. Dividend Equity ETF (SCHD) which currently offers a 3.43% distribution yield and holds 103 stocks from all sectors. True, XLU is yielding slightly more than the far more diversified Vanguard High Dividend ETF (VYM) which has a forward yield of only 2.86% drawn from 551 stocks selected from the total U.S. stock market, but again the diversification of VYM gives it an advantage. Bad news coming from one Utility company debacle won't tank it. Finally, for income investors whose prime concern is safety, treasury bonds and FDIC insured CDs still offer much better yield, even out to 5 years. Vanguard Bond and CD Rates 8/20/2024 Vanguard History Suggests There Will Be Far Better Entry Points if the Market Experiences a Significant Decline Looking at the charts of XLU's behavior in the past, we see that though it was an excellent alternative to the S&P 500 during the \"Lost Decade\" of the 2000s, it was a far better investment when bought after the S&P 500 had dropped dramatically after the Dot.com bust. Buying it at the height of the Dot.com boom provided far less impressive results, though it did provide a better total return than the S&P did. We can also see from the charts above that when the market as a whole drops, XLU drops too, reliably offering much better entry points - and much better dividend yields - to those wanting to flee the broader indexes. The \"flight to safety\" into utilities doesn't seem to kick in until their price has declined enough to make their yield very attractive - at a point where investors have become convinced that Something Very Bad will happen to the market as a whole for a prolonged time. But so far, we are relying very heavily on backtesting XLU and backtesting is dangerous because the challenges facing utilities in 2024 are far different from those facing them in 1998. The Increasing Pace of Disasters May Make XLU Less Safe Going Forward Whether or not you \"believe\" in climate change, you must certainly have noticed the increase in record temperatures stressing power grids, hurricanes wreaking havoc on large urban centers, flooding damaging urban infrastructure, and forest fires raging out of control. All these climate-related disasters have already proven to be very costly to utilities. In the worst case, in 2019, exorbitant forest fire-related liabilities caused California's PG&E to declare bankruptcy. Increased Demand For Power: A Plus or Minus For Utilities? Some optimists have been investing in Utilities since the advent of the ChatGPT-induced AI craze this year, reasoning that the enormous power demands these systems make will increase electric utilities' profits. They see power utilities as the companies selling \"picks and shovels\" for the AI gold rush. Optimists also project that the increasing use of Solar, Wind and other alternative power sources will help increase demand and utility profitability. Aging 20th Century Infrastructure Poses A Threat to Earnings But these optimists overlook just how strained power grids are currently, to the point that many can barely keep up with the demand for air conditioning as temperatures head upwards of 100 degrees. In my region - rural Western New England, a large, fully funded solar farm project, which was supposed to add many kilowatts of power to the local supply, had to be cancelled because Eversource (ES) was unable to connect the farm to its existing transmission lines. It is likely that the costs of upgrading grids to provide the power needed to support the demands of a warming climate, repair infrastructure damaged by punishing storms, and supply additional power to run AI processors and fuel a growing population of EVs will be enormous. These costs are likely to limit utility earnings growth for a decade or more. Water utilities are similarly challenged, as many urban water systems were installed more than a century ago and suffer from problems like dangerous pollutants in their water supplies, cracked and leaking pipes and the like. As you can see from the chart below, given the challenges utilities have been facing, the earnings of XLU's holdings have not been impressive over the past 5 years. There is no reason to believe they will improve any time soon. XLU 5-Year Price Return and EPS Seeking Alpha XLU Invests In A Very Few Stocks XLU has one significant issue that stands out to me as a concern as a long-time ETF investor. It holds stock in very few companies. Seeking Alpha As you can see, three stocks, NextEra Energy (NEE), The Southern Company (SO) and Duke Energy (DUK) make up 30% of the value of the entire ETF. NEE's valuation is rated D- by Seeking Alpha's Quant system. It's forward P/E ratio of 23.28 is concerning. The Southern Company's valuation is also challenging. It is rated D+ by the Quant rating system and its forward P/E ratio is 21.55. Duke Energy's P/E is better at 18.87, but it makes up a much smaller percentage of XLU's total value than NEE. Indeed, it looks like bad news for NEE is bad news for XLE, no matter what happens to its other, much smaller holdings. Its Competitors Hold More Stocks but Are Still Dominated by the Top 3 XLU only buys shares in utilities that are held in the S&P 500. Would other popular Utility Sector ETFs be a better choice? The slightly more popular Vanguard Utilities ETF (VPU) holds more than twice as many stock - 66 stocks. It's P/E of the ETF is higher than that of XLU, at 20.9, though, so it too holds stocks that are very highly valued given the slow growth of Utility company earnings. VPU is still dominated by the same top 3 stocks as XLU and because Vanguard doesn't report daily holdings percentages, it is difficult to know how much of VPU's total value those top 3 stocks make up. As of July 31, 2023, the last date for which data is available for VPU, those 3 stocks made up only 27% of the value of the entire ETF, but NEE has risen almost 6.6% since July 31, making it likely that NEE makes up a very similar percentage of the value of VPU as it does of XLU, despite VPU holding stock in more companies. The iShares U.S. Utilities ETF (IDU) is a far less popular Utilities Sector ETF with only $1.3 billion of assets compared to VPU's $7.6 billion (including mutual fund share classes) and XLU's $17.3 billion. It holds shares in 44 companies. The top 3 companies, NEE, SO, and DUK make up 26% of its value. It's P/E ratio as of August 19 is very high at 22.94. From this, we can conclude that XLU though less diversified than its major competitors in the market cap weighted utility sector ETF world is likely to perform very much as they do, that any utility sector ETF is going to be at the mercy of its \"Magnificent 3,\" and that all market cap weighted ETF sector ETFs are valued at nosebleed levels. Bottom Line: There is No Compelling Reason to Invest in XLU Right Now XLU's yield is not significantly better than that of competing, large, income-oriented ETFs, and its concentration in just 31 stocks is worrisome. Its valuation is very high for an ETF holding the stocks of slow-growing companies subject to stringent government regulations. If the market tanks, it has a history of tanking too, which makes it a much better idea to hold off investing in XLU until after a market meltdown if you feel the need to own utility stocks.  The growing challenges brought about by a combination of climate disasters, aging infrastructure, and increases in demand for power that will require expensive infrastructure build outs suggest that reliance on backtesting against the performance of the utility sector of 25 years ago is a mistake. There are better safe havens for your money if you aren't comfortable investing in the broader market now. And if you are investing for income alone, you can still get a better rate investing in treasuries.","kind":null,"is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":0},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2461498698"}