What was the best performing sector of 2014 may not be so for much longer.
Historically, this has been the go-to sector for yield-hungry investors. Add in the easy-money, low interest rate central bank policies being implemented across the globe and it's no surprise that this sector has been doing so well.
In the late 1990s and early 2000s, income investors earned 5% on Certificates of Deposit (CDs) and consistent yields from the largest, most stable stocks in the Dow Jones Industrial Average (DJIA). Now, they must invest their money elsewhere to capture similar yields.
Even 10-year government bonds were returning a solid 5-to-8% over the last couple decades.
Last year you would have earned a paltry 2.6% yield if you invested in a 10-year government bond, 1.8% if you invested in the DJIA and a measly 0.9% investing in a five-year CD.
However, income investors could have garnered an impressive 3.9% yield from 2014's best-performing sector, utility stocks, had they bought shares of the Utilities Select Sector SPDR ETF (NYSE: XLU) in January 2014
So again, it's understandable why the utility sector has seen such an amazing 2014, ending the year up more than 28%, compared to the S&P 500's 11.4% return.
But more than doubling the S&P 500 in just one year seems a little aggressive.
Currently, XLU trades at a price-to- earnings (P/E) ratio of 19, a bit higher than the S&P 500's P/E of 17. That means investors are pricing these historically slow-moving stocks to grow faster than the aggregate of the broader market.
While utility companies do benefit in a low interest rate environment, it's not a high-growth sector that deserves such a high P/E ratio.
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Simply put, I think this market is overheated. The reasons investors are flocking to this sector are understandable: chasing high yielding investments that benefit from low interest rates.
But I'm nervous, because there are more risks to end this run than there are tailwinds to propel it further.
While the Federal Reserve's actions are up for debate, October marked the end of the quantitative easing program. The bond buying program pumped more than $1.6 trillion into treasury bonds and mortgage-backed securities, which helped push interest rates near zero.
With the Fed out of the picture, there's a much higher risk of a rate rise should investors start leaving the treasury markets.
If that happens, then the utilities' earnings will be under pressure from higher interest payments on their debt. Historically utilities companies have large amounts of debt to fund their significant investments in infrastructure. For example in Q3 of 2014 the average debt-to-equity ratio for utilities companies was 1.4 compared to the S&P 500's 0.84.
How Overstretched Is This Sector?
To get a better picture of how extreme prices are, I looked back over the last five years of utility stock price data in comparison to its rolling one-year moving average. What I found was astonishing.
If you're not familiar with moving averages, they're simply trailing averages of a stock's price. For example, if you look at XLU's price on January 4, 2013, then the moving average would be the average price between January 4, 2012 and January 4, 2013.
There are plenty of time periods that investors consider and different implications associated with each. Many short-term traders will watch the 20-, 50-, and 100-day moving averages.
I used the one-year moving average because I wanted to get a longer term picture of where prices have been and where they're at now. Furthermore, I wanted to examine how that difference compares to the differences from the averages for the prior five years.
The fact that utilities prices are above the one-year moving average comes as no surprise. It’s a mathematical fact considering XLU's growth over the last five years. Visually, it's clear that XLU is currently much higher above the moving average than it has been over the last five years.
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Taking this analysis a couple steps further, I wanted to see statistically how far stretched XLU was.
I added in an upper bound, which defines the level where more than 95% of the past years' prices fall below. Put simply, XLU has been trading at a level where prices have been only 5% of the time in the past year.
It came as a huge surprise to me that XLU has recently been dancing above that level. Statistically that is remarkable. In fact, over the last five years, XLU has closed above that level only 46 times out of the 1,261 trading days.
All of this data screams that XLU had an amazing run and that it is likely to come under pressure soon. There are some major takeaways from this that short- and long-term investors should consider.
For short-term traders there are a couple of ways you could play this -- and the data backs it up.
I back-tested two situations: shorting XLU for a 20-day holding period and a 60-day holding period from when the level was breached.
Although XLU has broken this level 46 times, some of the observations were so recent that they're excluded in the chart below as the 20 and 60 day holding periods have yet to end. Put simply when you add up the winners and losers columns they won't equal 46.
The results speak for themselves. This is a very low-risk opportunity to utilize a short-term trade for solid returns.
Another opportunity presents itself by simply buying shares of the ProShares UltraShort Utilities ETF (NYSE: SDP). This is a leveraged ETF that roughly returns double what shorting the XLU would.
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For example, look at what happened since the last time the upper bound was breached on December 29.
The results were pretty compelling.
Had you used that level as a trigger and shorted XLU or bought SDP when it breached that upper bound, you would have earned 2.97% or 5.04%, respectively, in one week.
You could have initiated the 60 day trade with more than 90% certainty that you'd make money, and already you would have made a few percent in just seven days.
But let's be honest, not all of us are short-term investors.
For the long-term crowd, I'd take this as a sign that the utilities sector is trading at extremes. If these types of prices have only been seen for 5% of the past year, then that is a pretty clear indicator that it could be time to take some of your profits and re-enter the sector once it cools off.
Risks To Consider: Shorting comes with its own risk. With any short-term trade (or long-term for that matter) be sure to put in a stop-loss order to limit any potential losses.
Action To Take --> If you're looking for a trade or even simply a hedge on your portfolio, short utilities. Although XLU isn't currently above the level I've written about, it wouldn’t take much of a rally to get back up there. I see some significant downside risk and any current holders should look at taking some profits now or avoid the sector.
For the past 18-months, my colleagues were testing our Maximum Profit strategy -- which uses relative strength combined with a little-known fundamental indicator that's been shown to beat the market 3-to-1 -- with only a select group of people. They've booked gains of 40%, 85% and even 181% all in less than 13 months, and our current holdings include stocks that are already up as much as 65% in less than eight months. To learn more about this research, I encourage you to watch this presentation.