Earlier this year, utility stocks were among the best-performing segments of the market as investors turned to defensive sectors to weather the financial storm. Utility stocks are typically thought of as more stable than overall equity markets as providers collect steady checks from customers even when the economy slows. At its 2022 high in mid-September, the S&P 500 utilities sector was up more than 8% year to date.
That trade has unraveled. Over the past month, utility stocks have been the worst-performing sector of the S&P 500, down 14% versus the broad benchmark’s 5% decline. All but one of the 28 stocks in the group have pulled back, including Consolidated Edison Inc., Duke Energy Corp. and Dominion Energy Inc. Last week, the utilities sector dropped to its lowest level of the year.
A big draw of utility stocks has become less attractive as interest rates have climbed. Utility stocks are known for their sizable dividends, offering investors a regular stream of income. Companies in the S&P 500 utilities sector offer a dividend yield of 3.3%, among the highest payout percentages in the index, according to FactSet.
But the outsize dividends of utility stocks are no match for climbing bond yields. The yield on the benchmark 10-year Treasury note finished above 4% on Monday for a second consecutive session. Friday marked the 10-year yield’s first close above the 4% level since 2008 and 11 straight weeks of gains. Treasurys are viewed as essentially risk-free if held to maturity.
“The 10-year is repricing everything. I’ve got something that’s even safer and yields even more," said Kevin Barry, chief investment officer at Summit Financial, comparing Treasurys and utility stocks.
The rout in utility stocks underscores the difficulty of finding havens amid this year’s bruising market conditions. With inflation still hot, the Federal Reserve is on track to keep raising interest rates at an aggressive pace, even as investors worry the economy could tip into a recession.
Despite the recent pullback, utility stocks look expensive to investors compared with the broader market. Wall Street often uses the ratio of a company’s share price to its earnings as a gauge for whether a stock appears cheap or overpriced.
After the run-up in utility stocks earlier this year, the S&P 500 utilities sector is trading at 16.6 times projected earnings over the next 12 months, according to FactSet. That compares with the S&P 500’s multiple of 15.3. Analysts estimate utility companies’ profit dropped 5.8% in the third quarter, compared with S&P 500 companies’ roughly 1% projected earnings growth.
“There was a big piling in there, and valuations have gotten too stretched," said Stephanie Lang, chief investment officer at wealth management firm Homrich Berg.
Rising energy prices are unlikely to boost utility stocks, because changes in commodities prices are typically passed through to customers, analysts and investors say. Brent crude has retreated from its highs of the year but is up 4% in October.
Plus, the high dividend yield and projected earnings growth of oil-and-gas companies also make those shares more appealing, Ms. Lang said. Energy companies in the S&P 500 are expected to report that their profits more than doubled in the third quarter, according to FactSet. The energy sector has a dividend yield of 3.5%.
Some investors say they are continuing to maintain a defensive posture in their portfolios, but looking to other safety sectors like healthcare and consumer-staples stocks. Victoria Fernandez, chief market strategist and portfolio manager at Crossmark Global Investments, said her firm is slowly adding to its holdings in those sectors.
“We know there’s going to be more volatility," said Ms. Fernandez.
To be sure, utilities are still outperforming the market this year. The sector is down 11% in 2022, compared with the S&P 500’s 23% pullback.
For investors with a longer time horizon, the transition to clean energy could be a boon to utility stocks for years to come, said Jay Rhame, chief executive and portfolio manager at Reaves Asset Management, which invests in utility and infrastructure companies.
Mr. Rhame said his firm is positioning portfolios toward companies it thinks will be long-term winners from the Inflation Reduction Act, which provides subsidies for renewable energy projects. The biggest holding in the Virtus Reaves Utilities ETF is NextEra Energy Inc., one of the world’s biggest renewable-energy developers.
“With the upside of the IRA and the regular stability of utility earnings, we think they will come back to being defensive," Mr. Rhame said about utility stocks.
