The Year of the Utility

31 Dec 2014 | Author: | No comments yet »

After 2014’s party, investors in U.S. stock market may face a hangover.

A strong U.S. economy helped propel the stock market higher in 2014, continuing a bull market that is on pace to celebrate its sixth birthday in March.The S&P 500, which accounts for about 80 percent of publicly traded companies in the United States, is trading at near record levels with a price-earnings ratio of about 19.7.Utility investors should be forgiven for popping the champagne a little early this year, as they have much to celebrate: Utilities produced a stunning 33.1% total return in 2014, outperforming all other sectors in the S&P 500, while more than doubling the broad market’s return. Agence France-Presse/Getty Images With the U.S. economy growing at its fastest clip in more than a decade, the Federal Reserve is widely expected to raise interest rates in 2015 for the first time in nine years.

This is a bit above the 18.90 average for the past 25 years but hardly overpriced if we consider how efficiently corporations use capital to create value these days. This performance has once again proved that utility stocks are the ne plus ultra of equity-income investments, especially when safety and stability are in high demand. The Fed’s easy-money policies have helped support the nearly six-year bull market, but a rate increase could damp economic growth and make it more expensive for companies to expand. In the digital age, software can be used to create whole new industries — like e-commerce and social networks — or to improve existing products and services at much lower cost than by simply adding buildings and equipment, as was required during the machine age.

Though most economists viewed the Federal Reserve’s taper of its extraordinary stimulus as a positive sign for the strengthening of the economy, many investors were not so sure. However, the S&P 500’s forward price-to-earnings multiple – based on 2015 earnings expectations – is at about 17 now, exceeding the 15-year average of about 15.

That’s why U.S. corporations are flush with billions in extra cash — they don’t lack for new opportunities to earn profits but need less money to do so. And the huge 2.1% contraction in gross domestic product (GDP) during the first quarter increased concerns that the economy was still too weak to stand on its own without the Fed’s monetary largesse, stoking fears that the economy could reverse course and fall into recession. Hence, they use that extra capital to buy back stock and, along with individual investors, bid up prices for young companies like Uber that exploit new concepts.

And geopolitical shocks such as Russia’s annexation of Crimea gave the world an unwelcome reminder that political tension, if not outright conflict, can easily undo economic gains and hinder global trade. Whether consumers and companies benefit enough from lower oil prices to more than offset the effects of the slide on the energy sector is also critical. “Multiples almost always go down when the Fed raises rates – you’re going to have to depend on earnings,” said Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, which has $345 billion in assets under management.

GDP was on the mend, spiking 4.6% in the second quarter and a further 5% in the third quarter, global growth began to slow in parts of Europe, Asia and Latin America. With European and Asian economies weakening, the rush of foreign investors into dollar denominated investments has further boosted stocks and pushed down bond yields. Since 1940, such a level is associated with S&P returns (excluding dividends) of about 5 per cent over a 12-month period, according to data from Citigroup.

The S&P 500’s forward price-to-earnings ratio sat at about 13 times at the beginning of 2013; it is now closer to 17, according to Thomson Reuters data. Higher home values, a better jobs market and lower gas prices put consumers in their strongest position in nearly a decade, and they are poised to drive stronger GDP growth in 2015 — and even more profits for U.S. businesses. Some believed the sudden decline was a response to the official conclusion of the Fed’s stimulus, with investors anticipating a revaluation of the market as a result.

Stocks have been noticeably more volatile in the last few months; the CBOE Volatility Index, or VIX, has averaged 15.4 over the past 12 weeks, compared with 12.6 at the end of August. If the Fed tightens, the higher rates will not only raise financing costs generally but would also be a deterrent to borrowing to do the share buybacks that have helped to propel earnings per share growth and stock prices gains in the past few years. Factoring in accompanying growth in profits, the index’s P/E ratio would still be well below 25 — the level it hit when the index first pierced 1000 in 1998. The collapse of oil prices has hit energy stocks hard, and professional money managers will be looking for bargains among smaller oil producers, for example: those not heavily indebted and who can rein in drilling and production costs.

Europe is expected to grow at just above 1 percent in 2015, according to Reuters data, Russia has been slammed by oil’s decline, and China and other major emerging markets are struggling with weak demand as well. Russia’s currency, the ruble, has slumped in recent months because investors are concerned that the government could default or that the country could slip into a recession. Also, now may be a good time for professional investors to look at some of the stronger Japanese and European companies and banks whose stock prices will rebound when the yen and euro strengthen again. Picking winners among companies and currencies is too complex for the ordinary investors — they simply don’t have the time and information needed to make good bets. The big question for next year is whether the world is simply producing too much oil, or whether the global economy is not strong enough to consume it fast enough.

Also, if prices keep falling, will oil producers start cutting back production, which in turn could provide some support for oil prices? “I still believe what’s happening to oil is related to there being too much supply, but the sell-off is sending ripples through the market about global economic growth,” said Sonders of Charles Schwab. Many U.S. firms quite effectively profit from developments abroad, but if you wish further international diversification, put about 20 percent of your portfolio in the Vanguard Total International Stock Index Fund, which tracks non-U.S. equities, or a similar vehicle fund at another low cost service.

To understand why stocks can thrive at such times, think of low interest rates as medicine for the economy: You take it away only when the patient is healthy. Citigroup’s chief equity strategist Tobias Levkovich, in a note on Tuesday, said estimate cuts in the next few weeks, when companies typically warn if they expect to report disappointing results, could lead to some reversals and volatility, as “some of the late 2014 S&P 500 gains appear to have been borrowed from 2015’s returns,” he wrote. For the last 40 years, that’s how my wife and I invested most of our money, and we are well prepared to retire and travel — but I like doing these columns too much to quit. The economic sanctions the European Union put on Russia for its invasion of Crimea impacted Germany’s economy, Europe’s largest, far more than originally anticipated. Since then, Europe has teetered on the brink of recession. “There are low expectations for Europe’s recovery, which means prices are low,” Koesterich said.

Crude’s selloff has also given the Fed confidence to start raising short-term rates again, possibly as soon as the middle of next year, assuming that low oil prices keep inflation in check. In Europe, investors are paying roughly $14 for every dollar of European company earnings compared with the $17.50 investors are paying for every dollar of U.S. earnings. For example, the Fed announced in June 2004 that it was boosting its key short-term interest rate by a quarter point, to 1.25%, and continued to tighten through 2006. Further, there are also fears that a strengthening dollar will make U.S. exports more expensive overseas, and that could cut into the profits of many U.S. companies. So far in the fourth quarter, expectations have fallen largely due to the energy industry’s woes, but sectors that could benefit from lower fuel costs, particularly the consumer discretionary sector – which includes many retailers – have not seen an attendant pickup in expectations.

While the stimulus helped briefly, the Japanese government had to raise taxes to cover the cost of the program, effectively negating what the officials were trying to do. But stock-market investors may shrug off a rate rise if they see it coming, says Anat Admati, a professor of finance and economics at Stanford University who has studied how markets respond to information. Thanks to their pricing power, utilities are excellent investments during deflationary periods because they hold their value while continuing to deliver income. Even an increase of a couple of percentage points would leave rates at a level that for much of the nation’s recent history would have seemed strikingly low.

That said, it’s not as if 2014 didn’t have its rough spots, either, and yet the year is ending with a flourish. “In the spring of 2014 the market went nowhere for three months. Last week, my colleague David Dittman observed that despite challenges ranging from rising capital expenditures to low load growth and competition from new market entrants, the utilities industry is well down the road toward long-term transformation. “Opportunities for the future are starting to come into focus. Many of the moving pieces around fuel prices, renewables, customer interaction, managing distributed generation, electricity storage, demand response and energy efficiency are beginning to fall into place,” he wrote. Nevertheless, many investors are doubling down on their bond yield forecasts for 2015, with some looking for the 10-year yield to reach 2.5 percent to 2.75 percent next year. Further, he noted that utilities are taking concrete, financially sound steps to incorporate these elements directly into their business models to seize opportunities for growth, as opposed to ceding this playing field to new competitors.

Those utilities that have taken these challenges seriously and positioned themselves accordingly will deliver value to shareholders in 2015 and beyond. We’re pleased to announce that Utility Forecaster was just named “Best Stock Newsletter” in Kiplinger’s annual “The Best List.” Fortunately, the best is still available at a reasonable price.

Conventional wisdom suggests sectors which thrive in a growing economy could do well as rates start to rise, which could mean large manufacturers or companies that benefit from discretionary spending by consumers, such as luxury goods and airlines. But rather than worrying about how Fed policy might affect the market—which you can’t control—it could be more profitable to focus on your own investing temperament, which you can.

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