Time to Flip the Switch from Energy to Utilities

November 4, 2021 by Herb Blank

This week’s blog focuses on a trade recommendation based upon many data elements found in ValuEngine reports combined with industry experience and knowledge. At the end-of-June blog, “Drill. Baby, Drill”, I focused on the 5 (Strong Buy) recommendation that the ValuEngine models had on the iShares US Oil & Gas Exploration & Production ETF (ticker IEO). The blog recommended that for trading purposes IEO would likely outperform the market in the next 3-to-6 months, but it was not a recommended buy for long-term investors. Four months have passed. That recommendation, fortunately, was on the mark.

IEO significantly outperformed the SPDR S&P 500 ETF (ticker SPY) by State Street Global Advisors (SSgA) during the past four-months: 12.5% as compared with 7.6%. Since ValuEngine models are dynamic and based on a multitude of factors, it can change significantly in a few months. IEO now has a rating of 1 (Strong Sell). The price run-up combined with fundamental, technical, economic and market-relative changes contributed to the decline. Beyond that, long-term investors should still stay away from fossil-fuel-related stocks, especially those in and servicing the drilling industry. Global climate change concerns have led many businesses and governments to institute plans to find alternatives to fossil fuels. These changes are anticipated to severely limit future earnings.

For those looking to utilize profits taken in Energy ETFs, I recommend taking a long look at the Utilities Sector ETFs. The largest of these in assets under management (AUM) is XLU and is currently rated 4 (Buy) by ValuEngine.

Let’s take a closer look at the data behind the numbers. The below data is as of October 31, 2021. The bold numbers denote the ETF with the most favorable score in the category.

The first four rows show the rating and forecasts produced by ValuEngine models. IEO uniformly had the worst predictions for all the upcoming periods. Since it was a tactical buy based on timing, now would be a good time to sell IEO. The best in each category is Utilities. The opportunity to get into a Utilities Sector ETF now might be even more attractive than the differences displayed in these rows, especially for income-hungry investors. Here are some reasons why I think XLU is so attractive now:

1. It is highly unusual for utilities sector stocks or ETFs to be rated anything but 2 (below market performer) or 3 (market performer). One reason is that they are highly regulated, and their profitability is controlled by set upper boundaries. During periods of market expansion, this is very limiting.
2. Our ratings models are based upon projected price appreciation, they do not project total return or account for dividends.
3. On the other hand, utilities investors take dividend yield heavily into account. Although a 3% yield is close to the low end of XLU’s historic range starting in Autumn of 1998, it is very attractive relative to the 1.2% yield offered by SPY – a difference of 250%.
4. From traditional valuation and risk tolerance perspectives, XLU also looks more attractive than SPY. Its volatility is lower; its market Beta is below 0.5; its Price/Book ratio and Price/Earnings ratio are also lower. Collectively, this indicates that utilities are valued more in line with their intrinsic value than the S&P 500 currently is. One utility stock we find particularly attractive now is Vivendi (VIVHY), the American Depository Receipt (ADR) of the French telecommunications company. It gets our highest rating of 5 to accompany a yield of 4.4%.
5. The next 12-months for the S&P 500 are projected to be very choppy according to the latest round table of market strategists. Our one-year projection for SPY of -3.7% is in line with that. Taken the 1.2% yield into account, a rough approximation of total return would be -2.5%. Conversely, a projected -1.7% return on price combined with a 3.0% yield results in a rough approximated total return projection of +1.3%. Investors with low risk tolerances might be less upset by a turbulent market if between one-quarter and one-half of their core US large cap allocation were shifted to XLU for the upcoming 12 months.

The utilities sector is generally considered boring but in a volatile market, boring can be a very reassuring place to be. My conclusion is that it is time to flip the switch and sell IEO if you bought it in June and shift some of your core US equity into a Utilities ETF such as XLU.