June 6, 2017 / 8:06 PM / 2 years ago

Outsized gains for utilities stocks may be short-lived

NEW YORK (Reuters) - Sharp gains in U.S. utilities stocks have driven the safe-haven group to expensive levels, leaving doubts about how far the rally can go as equity investors look elsewhere for returns.

The sun sets behind power lines above the plains north of Amarillo, Texas, U.S., March 14, 2017. REUTERS/Lucas Jackson

Utility stocks, with hefty dividends, are among the sectors considered “bond proxies” and have benefited from declines in longer-dated Treasury yields this year.

“We think the utilities are overvalued,” said Alan Gayle, director of asset allocation at RidgeWorth Investments. “They are getting a last tailwind from this drop in yields, but I don’t think that it will persist.”

Goldman Sachs, Bank of America-Merrill Lynch and Credit Suisse have recommended since last year that investors be “underweight” in utilities. Major investment banks generally are preferring sectors that should thrive during economic expansions.

“Being in a growth cycle, we would like to take the money out of utilities,” said Paul Christopher, head global market strategist at Wells Fargo Investment Institute.

About $800 million flowed out of U.S.-listed mutual and exchange traded funds this year after $4.7 billion in such outflows in the second half of 2016, according to Lipper data. Still, the S&P 500 utilities sector has climbed 10.5 percent this year, topping an 8.6 percent rise for the overall S&P 500 index.

The sector includes power and energy companies such as NextEra Energy, Duke Energy and Dominion Energy and offers an overall dividend yield of 3.4 percent.

The yield on 10-year Treasury bonds, which analysts compare to utilities, on Tuesday fell to 2.13 percent. That was the lowest since just after President Donald Trump’s Nov. 8 election stirred expectations of inflation and increased growth that lifted 10-year bond yields.

“The basic fundamental reason for the decline in the 10-year yield is that investors are looking for safety,” said Ali Agha, analyst at SunTrust Robinson Humphrey. “That is the same dynamic that would lead to them to utilities.”

Utilities are trading at a 2 percent premium to the broader market, based on price-to-earnings ratios. Historically, the group has traded at a 7.5 percent discount.

Analysts expect virtually no profit growth for the sector this year, according to Thomson Reuters I/B/E/S.

Results may be hurt as milder weather crimps power demand this year and margins are pressured for companies operating in deregulated power markets, Evercore ISI analyst Greg Gordon said.

But the highly regulated nature of most utilities means investors should be able to count on mid-single-digit profit and dividend growth over the next three to five years, Gordon said.

(To view a graphic on 'Utilities stocks vs. other "bond proxy" sectors' click reut.rs/2swa4nO)

Bond-proxy sectors historically have been relied on for a “smoother ride” than the broader market because they rise less in a market rally and fall less in a sell-off, said Jonathan Golub, chief equity strategist at RBC Capital Markets.

But that link has weakened recently.

“The market is getting increasingly concerned about interest rates and therefore the groups that are normally the most sensitive to rates are becoming hypersensitive,” Golub said.

“If we were to see rates go up toward, let’s say 3 percent, on a 10-year bond, I think that these guys have the risk of getting clobbered.”

Additional reporting by Sinead Carew; Editing by Megan Davies and Richard Chang

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