What’s the Matter with Utilities Stocks?

Utilities Performance

2015 has so far been a middling year for the stock market, with the S&P 500 index of large US stocks up slightly since the start of the year. But one sector of the market has stood out: utilities have been by far the worst-performing sector among US stocks, losing more than 6% while almost every other sector has provided investors with positive returns. What’s causing utilities to struggle?

The utilities sector is comprised of companies such as electricity and gas providers whose businesses and profitability are heavily regulated by the government. That regulation makes utilities less tied to the ups and downs of the economy than other sectors. Utilities are therefore generally considered “defensive” stocks, meaning that they often lag the overall market when the market does well and outperform when the broader market struggles.

But this year hasn’t been a banner year for the stock market, so that phenomenon doesn’t explain why utilities are lagging. And last year utilities were actually the top-performing sector even as the S&P 500 index posted double-digit returns.

Instead, the explanation is likely related to another characteristic of utilities stocks: their fairly stable profits allow them to pay substantial dividends to their investors. With the Federal Reserve keeping its benchmark interest rate near zero to try to boost the economy, some investors have viewed the dividends paid by utilities stocks as an alternative way to generate income from their portfolios.

That increased demand for utilities stocks likely explains part of the sector’s surge in 2014, and it’s made utilities more expensive by many valuation metrics. According to data from Yardeni Research, the forward P/E ratio for the utilities sector at the start of 2015 was among the highest of all the sectors (although it’s since fallen back a bit due to the sector’s poor returns this year).

The lofty valuations, combined with the possibility that the Fed could start raising interest rates later this year, have likely made the sector less attractive for many investors. This explanation suggests that utilities’ struggles could continue as the era of near-zero interest rates comes to a close.