As the market looks set to gap lower for the second straight session, and the S&P 500 index now at 2 month lows, the sector rotation in the past week has not exactly been typical for a selloff. The health care and consumer discretionary sectors have held up better, while energy and utilities have been hard hit.
The utilities sector has gone from hero to zero quite quickly over the past month. The sector was the best-performer in 2014 just a month ago, but traded at a 4 month low this week and has ceded its leadership spot to the health care sector. Interestingly, the underperformance in utilities has occurred even as Treasury yields have fallen in the past week. The technical situation in utilities looks akin to a failed breakout after the late June high (see my NTT post from last week for more detailed analysis of the sector).
Meanwhile, REITs, which have been highly correlated with utilities (and inversely correlated to long-term interest rates), have actually held up quite well. The divergence between REITs and utilities is evident on the 1 year performance chart:
XLU is now only up 4% in the past year, while IYR is still up 8.5%. The recent selloff has moved XLU’s dividend yield to 3.62%, slightly higher than IYR’s yield of about 3.58%. While utilities and REITs are hardly related industries, the stocks generally have a similar investor base – investors who covet higher-yielding investments with less cyclical risk.
Of course, the cyclical risk in REITs can be quite substantial if the real estate market takes a tumble, as happened in 2008. However, in the current market environment, low levels of debt have offered a safety net for REITs as they re-financed their loans at much lower long-term rates, giving them a measure of security for short-term business distress.
While the business risks in utilities are less volatile, it’s rare that utilities outperform REITs in a period of the bull market where risk appetite is voracious. The recent decline has brought XLU back under IYR on the 2 year performance chart:
When looking at valuations in the defensive sector, we have pointed out for more than a year now that utilities and staples stocks looked quite expensive, even for their purported safety benefits. In fact, since my April 2013 CotD post, the utilities sector is essentially flat, while consumer staples are up less than 10%, significantly underperforming the broader market. Health care remains the one standout, where valuations look more reasonable even with the appreciation over the past year (mainly since earnings growth has been easier to come by).
In that sense, the continued strength in REITs seems more a surprise, especially given the recent weakness in credit markets. High yield credit spreads are near 9 month lows:
With that backdrop and the crowded nature of higher-yielding stocks as well, we would expect IYR to catch “down” to XLU if the broader market selloff continues in the coming weeks.
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