Could Utilities Stocks Take a Hit After a Year of Transformation?

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Could Utilities Stocks Take a Hit After a Year of Transformation?

Over the first half of this bull market, utilities stocks lived up to their classic reputation as a defensive sector, delivering precious little in the way of gains, but reducing portfolio risk while paying reliable dividends.

But over the last 12 months, this sector has transformed. Like an aggressive NFL defense scoring immediately from turnovers, utilities have been putting a lot of points on the board.

The sector’s transformation this year is clear from the performance of the $19 billion SPDR utilities ETF The Utilities Select Sector SPDR® Fund (NYSE:). As of Oct. 24, this ETF had a paltry three-year return of 22%. But the last 12 months have been a different story entirely. During that *******, the fund gained about 43%.

Headlining this breakout year for the sector is electrical power company Vistra Energy Corp (NYSE:), the highest-performing stock in the . It has returned about 226% YTD.

Powerful Transformation

Who expected this from your father’s defensive sector — and probably yours for most of your investing career? Well, given America’s (and the world’s) obsession with things digital and rechargeable, perhaps more investors should have.

Further, though the market initially over-projected the adoption of electrical vehicles, its focus on all things digital and many things electrical might have been a clue about increasing demand for electricity.

Propelling this demand is an endless profusion of new rechargeable electrical consumer products — everything from lawn mowers to self-guided vacuum cleaners to interactive dog toys to teeth flossers, and on and on. Better rechargeable battery technology has eliminated much of the need for consumers to buy traditional batteries, and has freed them from cords and plugs once essential for many high-consumption appliances.

Electrical power demand is also increasing from cryptocurrency mining and the cooling needs of data centers. Anticipated demand from artificial intelligence technology is a new factor.

Private Nuclear

Some big tech companies involved in AI are themselves going nuclear for private corporate use. Insofar as tech companies influence public opinion, this may help rehabilitate nuclear power’s reputation as a bête noire.
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(NASDAQ:) has a 20-year deal with Constellation Energy to buy power that it plans to generate from a proposed restart of one of the mothballed reactors at Pennsylvania’s Three Mile Island nuclear plant (not the same one on the multi-reactor site that malfunctioned in 1979).

In addition, Alphabet (NASDAQ:) is investing in small modular nuclear reactors, Oracle (NYSE:) is planning a nuclear-powered data center and AI development guru Sam Altman is backing a startup planning to build a small reactor.

***** Image Rehab

Decades-old stigmas against nuclear plants are also wearing thin in Central and Eastern Europe, despite proximity to Chernobyl in northern Ukraine, where a reactor exploded in 1986, spewing radioactive material into the air for weeks.

Rising demand in the region and opposition to Russia from its invasion of Ukraine and the ongoing war there have resulted in a more positive view of nuclear power generation. Poland, Hungary, the Czech Republic, Slovakia and Romania have tentative plans for power plants using small reactors. (This is creating opportunities for companies like Westinghouse, which is already involved in the region.)

Here in the U.S., where power is generally much cheaper, society hasn’t warmed up to public use of nuclear power to the same extent as in Europe, though voices like Bill Gates’ are extolling its benefits.

Regardless, even with public support, it would take several years (maybe a decade) before any new plants for public utility generation could be built on ********* soil, as the process of getting regulatory approvals alone would be long, hard slog. (Currently, only a few dozen nuclear plants are operating in the U.S.)

In the meantime, rising domestic power demand will be met with using other methods of generation.

Joined at the Hip

The fortunes of power companies, of course, are joined at the hip with those of industrial concerns.

Both are benefiting from federal fiscal programs. This government spending, some of it directly on utilities, is projected to flow at an increasing rate to a wide range of infrastructure-related industrial companies (via the Infrastructure Act and the Inflation Reduction Act) and tech companies (via the Chips and Science Act) through 2026.

This legislation provides assistance for utilities development directly, stimulating industrials involved in utility plant construction, which heightens the synergy between the two sectors.

Currently, industrials stocks are experiencing their first multiple expansion since the pandemic. This, along with rising operating margins, is attracting new investment. More investors are noticing what Strategas analyst Chris Verrone in September called the sector’s position of “quiet leadership” in the S&P 500, when the SPDR industrials ETF The Industrial Select Sector SPDR® Fund (NYSE:) was up 38% for the preceding 12 months.

Also propelling rising industrial demand is the trend of reshoring — ********* multinational companies moving foreign plants on ********* soil. Corporate investment in such plants currently totals nearly $1 trillion.

Power Picks

Here are a few electrical companies with relatively low downside risk, as indicated by various fundamental characteristics, and sanguine earnings projections (as of last month):

• Entergy Corp. (NYSE:). Market cap: $29.3 billion. 12-month trailing P/E ratio: 15.7. Projected average annual EPS growth over five years: 7.06%.
• Portland General Electric Company (NYSE:). Market cap: $5.05 billion. Trailing P/E: 16.5. Projected annual EPS growth: 11.75%.
• ********* Electric Power Company Inc (NASDAQ:). Market cap: $53.6 billion; Trailing P/E: 20.3; Projected annual EPS growth: 6.3%.
• Duke Energy Corp. (NYSE:). Market cap: $93 billion. Trailing P/E: 15.9. Projected annual EPS growth: 6.6%.

Yardeni Scenario

Now that the Fed has started to cut interest rates, many analysts are projecting positive impacts on cyclical stocks. Yet many investors may not be aware that some defensive sectors have also done quite well historically during and after rate-cut cycles.

But what if the Fed decides against further cuts or to slow-walk them, leaving rates higher for longer?

This is a view you don’t hear much. But renowned market economist Ed Yardeni makes the case that with a soft landing virtually assured by the economy’s current robustness, the Fed may not see much need for significant cuts to follow the one in September.

In this event, investments that have been rallying on the anticipation of falling rates — including small- and mid-caps, REITs and utilities — could face headwinds. Though utilities’ earnings and earnings growth would probably still do well, the sector could still hiccup.

But the worst that could happen in this scenario would be for the sector to revert to its classic defensive role. This would involve reliable dividends that are now elevated and elevating, introducing a timely income dimension that reinforces dividend-paying utilities stocks’ virtue as a superior bond alternative.

Sector dividends increased 5.6% this year, and they’re positioned to do so again in 2025, especially among the few dozen utilities stocks that hold the venerable title of dividend achievers — those that have raised their dividends every year for at least a decade.

By contrast, there’s no such thing a rising fixed income yield, which is why they call it fixed. And unlike stock dividends, most bond income is taxed at the painful ordinary income rate.

So, if the monetary scenario posited by Yardeni develops and utilities take a hit, investors could be compensated with near-term income while awaiting growth from a likely resumption of Fed cuts.

Though defensive touchdowns from forced turnovers are the ultimate in football, many coaches would be happy just to have a defense that can consistently force punts — the analogue of the price stability and steady income from well-chosen utilities stocks.

And if the Fed continues to cut interest rates at a steady pace, which is quite likely, more defensive scoring would probably be in the cards in the near term for this remarkably transformed sector.

***

Dave Sheaff Gilreath, CFP,® is a founder and chief investment officer of Sheaff Brock Investment Advisors, a firm serving individual investors, and Innovative Portfolios,® an institutional money management firm. Based in Indianapolis, the firms were managing assets of about $1.4 billion as of June 30.

Investments mentioned in this article may be held by those firms or affiliates, Innovative Portfolios’ ETFs, or related persons.

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