The Fed Strikes Again

by Ari Charney, Investing Daily

Investing Daily Article of the Week

Just when utility investors were starting to breathe a little more easily, expectations about an imminent U.S. Federal Reserve rate hike have once again prompted a sharp selloff.

Since its recent high on Oct. 22, the Dow Jones Utilities Average has dropped 8%, with nearly half of that decline happening in today’s market session.

Although a somewhat lackluster earnings season is partly to blame, the Fed is clearly the main culprit behind today’s action – or, to be more precise, traders adjusting their bets in anticipation of the central bank’s next move.

While the Fed has been hinting more and more in recent weeks that it hopes to raise rates in December – Fed Chair Janet Yellen told Congress on Wednesday that such timing is a “live possibility” – the trigger for today’s sector performance was a jobs report that blew past economists’ expectations.

The economy added 271,000 jobs in October, well above the consensus forecast of 185,000.

Equally important, there are finally signs of wage growth: Average hourly earnings grew 2.5% over the trailing 12-month period that ended in October, up from an average of 2% that’s prevailed since the downturn. Yellen had previously stated that higher wages would be an important consideration in deciding when to raise rates.

These data make it increasingly likely that the Fed will finally raise rates at its December meeting. Indeed, based on futures data aggregated by Bloomberg, the vast majority of traders are betting on a December liftoff, with their positions indicating that the probability of a quarter-point hike now stands at 70%, up from 56% a day ago.

Still, there’s one more jobs report between now and the Fed’s decision on Dec. 16, so we certainly wouldn’t rule out our economy pulling the proverbial football away from the Fed yet again. Beyond that, some other disturbing event could transpire in the financial markets or the global economy that could forestall an increase. But the window of time for such an event is closing.

Beyond that, as long-term investors we welcome any shortsighted selloff that occurs due to a rate hike – or even mere expectations of a rate hike that never seems to come. In recent years, utilities have been pushed up to premium valuations, so we appreciate any opportunity to buy our favorite companies at a more reasonable price, while locking in a higher yield.

And at current prices, we’re on the cusp of seeing some values emerge, though we’re not quite there yet. The Dow Jones Utilities Average’s price-to-earnings ratio (P/E) now stands at 15.2, just above its trailing 10-year average of 15.1.

You know utilities have gotten ahead of themselves in recent years when even a sharp selloff isn’t quite enough to push the sector into undervalued territory. But we’ll certainly be happy to back up the truck and load up on stocks when we get there.

Additionally, as we’ve shown in the past, the conventional wisdom that utilities will underperform in a rising-rate environment isn’t necessarily true. That’s important to remember because it’s the very notion that sparks each and every Fed-related selloff.

Ned Davis Research conducted a landmark study that examined how stocks performed in each rising interest rate environment over the past 40 years. In general, they found that dividend payers tend to beat non-dividend payers, while dividend growers did even better.

Part of this outperformance is likely due to the reinvestment of dividends. While we know many of our subscribers depend on their portfolios to generate current income, those who are able to reinvest at least some of their dividends will create a foundation for enduring wealth.

Of course, we can’t ignore the fact that an underwhelming earnings season has some role in the recent decline.

All but one of the 29 utilities on the S&P 500 have now reported earnings, so we can start drawing some conclusions about how the third quarter went.

For one, utilities are still having a hard time finding growth in an era of declining electricity demand. Revenue fell 2.1% year over year, missing analyst estimates by 4.8%.

However, earnings managed to eke out a win, rising 0.2% year over year, for an upside surprise of 1.4%. For context, just half of the 10 sectors in the S&P 500 managed to grow their earnings from a year ago. So utilities are in good company.