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October 24, 2014

Utilities Shine in Market Sell-off

By Richard Stavros for Investing Daily 
While many portfolios were battered by the market’s recent selloff, which was just shy of formal correction territory, the Core Holdings in Utility Forecaster’s Growth Portfolio did a remarkable job of holding their value. In fact, our Core Holdings not only preserved wealth, they delivered growth, outpacing all of the broad indexes.
So far this year, our average Core Holding has outperformed the S&P 500 by nearly 8 percentage points, while one-third of the stocks in this sub-group have bested the index by double digits.
Beyond our individual holdings, the overall utilities sector has also enjoyed quite a run so far this year, second only to healthcare in terms of performance. In fact, the Dow Jones Utilities Average is beating the S&P 500 by more than 12 percentage points at present, with a year-to-date price gain of 17.6% versus 5.5%.
Notwithstanding utilities’ similarly incredible run in 2011, this type of short-term outperformance is rare for the sector. Instead, utility stocks tend to be slower and steadier than the broad market. Indeed, it usually takes a full market cycle, including both bullish and bearish periods, for utilities to exhibit superior long-term returns.
Of course, investors’ flight to safety is a big part of the reason utilities did so well in 2011 and appear poised to repeat that feat this year. And we believe utilities will continue to benefit from their safe-haven status as long as the economic uncertainty that drove last week’s selloff persists.
That brings us to the other major factor behind the utilities sector’s strong performance in recent years. In an era of historically low interest rates, investors who might ordinarily rely on fixed-income securities such as bonds for current income have instead been forced into dividend stocks such as utilities.
Until recently, the Federal Reserve had been widely expected to start raising short-term rates as soon as the middle of next year. But in the wake of last week’s selloff, Fed officials said they would consider delaying rate hikes if it became clear the US economic recovery would be hurt by slowing global growth.
And the action in the bond markets, where yields have plunged, suggests that investors believe the Fed won’t raise rates until later than previously anticipated, particularly as inflation has been weak and may not hit the Fed’s target for some time. That’s why central bank watchers believe rates may not start rising until late 2015, and then only modestly.
In fact, Goldman Sachs has cut its rate expectations, reducing its end-of-year forecast for the 10-year Treasury yield to 2.5% from 3%, while J.P. Morgan expects the 10-year note’s yield to end this year at 2.45% down from 2.7%. These levels are hardly adequate for those seeking income.
The Problem with a Strong Dollar
The strengthening of the dollar could contribute toward weakening of the US economy in the next year. The dollar is on its longest winning streak in more than 17 years and is now trading at a four-year peak against other currencies. Unfortunately, this is not a good time for the dollar to be surging higher.
A stronger dollar will make US exports more expensive to foreign customers, and that could cut into the profits of many US companies, which could derail the recovery. And the strong dollar could lead to price deflation, which could also weigh on the recovery.
While a strengthening dollar was not a big issue when US exports were a small part of corporate earnings, now more than 40% of profits for S&P 500 companies come from overseas. And these profits from higher-growth emerging markets have offset lower growth in the US and other developed economies.
Of course, some analysts believe that a higher dollar isn’t so bad. They think it’s just a reflection of investors looking forward to the Fed raising interest rates as the US economy improves. Higher rates mean higher demand for dollar-denominated debt, which pushes up the price of dollars. Some analysts have even speculated that the dollar’s strength will be a boon for US equity markets as it means more investment will come to US companies.
But that assumes our recovery is on solid ground. The US economy expanded at an annual rate of 4.6% in the second quarter, according to the Commerce Department. But that was after a first quarter during which gross domestic product (GDP) contracted by 2.9%. So declaring that the US economy has turned the corner is premature. The housing market still struggles, consumer spending is still weak, and the jobs being created are low paying.

The US economy is still projected to deliver a tepid 2% growth for the year, according to Federal Reserve projections. We’d like to see a few quarters of consistent growth before concluding the US recovery is here to stay. And the US economy would have to grow better than 3% annually before we could breathe a sigh of relief.
Though all of these considerations could be cause for anxiety, the good news is that utility investors are sitting in the catbird seat. If growth weakens in the US economy, utility stocks provide safety and income. If growth finally reasserts itself, utilities’ earnings will grow in tandem with the overall economy.
The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

Courtesy Investing Daily (EconMatters author archive here

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