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The hottest trade is about to face headwinds

Lawrence Lewitinn
Talking Numbers

The S&P 500 is at record highs but the sector leading the pack is ... the utilities sector?

Yes, old-fashioned dividend-paying utilities are the hottest sector this year. The S&P 500's utilities sector has returned 8 percent to investors so far this year, compared with the overall benchmark index's 2 percent year-to-date.

Now, here's the big question: Why are utilities doing so well?

After all, the Federal Reserve is tapering its bond-buying monetary stimulus program. That is expected to bring interest rates up in the long run as lower demand for bonds generally pushes yields higher.

Yields matter to utilities because they pay out relatively high dividends. As interest rates rise, investors tend to find utilities less attractive as higher rates compete for capital.

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In other words, utilities are cash-paying value stocks, not growth stocks. That's why the price-earnings (P/E) multiple on the utilities sector is a relatively sleepy 13.9 times earnings compared with the always-exciting health-care sector (21.3 times) or the almost-as-exciting materials sector (19.4 times). Even the overall S&P 500's P/E is 16.8 times.

So why are investors still plugged into utilities despite higher rates? According to CNBC contributor Gina Sanchez, founder of Chantico Global, there's a simple explanation for it and it requires looking back to when the Fed first hinted at tapering its bond-buying stimulus a year ago.

From mid-November 2012 to the end of April 2013, the Utilities Select SPDR ETF (the XLU), which tracks the utilities sector, gained roughly 20 percent and peaked at $41.62. But, from May 2013 to the end of the year, the XLU dropped 7 percent.

"Because everybody was concerned about the taper midyear in 2013, utilities really fell out of bed," says Sanchez. "So, they were really, really cheap."

That is, until the recent harsh winter. .

"We got hit with this massive 'Polar Vortex'," says Sanchez. "Everybody needed to stay warm and that was great for utilities. The combination of being really cheap and this huge demand surge was really, really good for utilities."

But interest rates and the weather could potentially put an end to the utilities rally, according to Sanchez.
"If we see rates crawling up to 3 percent and if we the weather starting to pare off," says Sanchez, "that could be pretty negative for utilities."

(Read: US CFTC pledges swaps relief for public utilities)

According to CNBC contributor Andrew Busch, editor and publisher of The Busch Update, the XLU's chart shows an uptrend support line that started at the end of 2012. The line has been tested several time and held. Currently, it's slight below $38. On top side of the chart is resistance at roughly $41.
"I don't want to buy it here," says Busch of the XLU. "I'd rather wait to buy it at $38."

Though Busch believes the "Polar Vortex" had an impact on utilities stocks this year, he sees particular companies in that sector as benefiting from another weather story in the months ahead.

"There's a big heat build in California and in Texas that will play out this summer," says Busch. "Probably the utilities in those areas will do pretty well."

To see the full discussion on utilities with Sanchez on the fundamentals and Busch on the technicals, watch the video above.