Investment Opportunities

It’s Time to Abandon Utility Stocks

Utility stocks are often referred to as “widow and orphan” investments…

Shares of utility companies have been a mainstay of conservative portfolios everywhere for generations. For risk-averse investors (such as widows and orphans), utility stocks have offered price stability, reliable income and minimal risk.

But in today’s unique environment, these same “stable” stocks are poised to break down dramatically, leaving disappointed investors in their wake.

If you own stocks of utility companies in your portfolio, you should think seriously about closing out (or at least hedging) your investment. There is too much risk to justify holding these names.

If you’re a more aggressive trader, I’ve got an opportunity that could double your investment as these stocks trade lower. I’ll explain how to set up this trade in a minute. But first, let’s take a look at the “perfect storm” setting up for the industry.

Dissecting the Bull

To understand why utilities carry so much risk, we first need to understand the dynamics that have driven the sector higher.

A large part of the industry’s strength has come as a direct result of the Federal Reserve’s actions. For more than five years now, the Fed has pumped liquidity into the market in an effort to prop up the economy and bolster employment.

The Fed has done this by setting interest rate targets at historically low levels, and then spending massive amounts to buy Treasury bonds and mortgage-backed securities. The massive purchase programs have pushed the price of these assets significantly higher, which leads to lower interest rates.

One of the Fed’s main goals was to drive the prices of these assets sky-high – so that they would NOT represent a good investment opportunity for conservative investors. (It doesn’t make sense to buy a Treasury bond yielding 2%, when inflation rates are expected to be much higher.)

The Fed believes that lower rates on Treasurys and other “safe” assets will cause investors to put their capital into other – more productive – assets. They reason that if investors instead buy more risky stocks, the additional capital will help companies grow, and by extension, help spur hiring and economic growth.

Since the Fed has caused Treasury bonds to be all but “dead money,” conservative investors have had to find other safe haven areas to invest in.

If you pull up a three-year chart of the Utilities Select Sector Fund (NYSE: XLU) you can see where the conservative capital has been flowing. The utility sector has been steadily increasing over the last few years, with the last few months representing one of the strongest advances this sector has ever seen.

Upon closer inspection, you will also notice that the most recent price action has been out of character for the sector. Over the past three weeks, utility stocks have become much more volatile and have dropped significantly on higher-than-usual volume.

This kind of action is a warning sign for any market. And it is especially troubling when you look at the dynamics that are causing utilities to decline.

Safe Havens Are No Longer Safe

Just as the Fed was behind the unprecedented advance in utility stocks, the Fed is also to blame for the recent weakness.

Over the last several weeks, the Fed has gingerly begun to signal that it will begin scaling back its massive asset purchase programs. The issue first surfaced as a “leaked” story published by The Wall Street Journal. (In actuality, no one really believes the story was leaked – but instead the Fed used the WSJ reporter to do the dirty work of breaking the story).

As investors have begun to digest the idea of less and less funny money from the Fed, it has become clear that “safe” investments are no longer very safe at all.

Keep in mind that the Fed has supported the safest of safe investments by plowing massive capital into these securities. This has pushed the price of ALL safe investments higher as investors search high and low for stocks that offer yield and stability.

Now that the Fed is starting to withdraw from its asset-buying programs, the flow of capital is reversing OUT of the second-tier safe investments like utilities. This is because interest rates are rising and there are better options available for conservative capital.

As a result we have already begun to see significant selling in the utility sector. Prices have begun to fall and investor fear is on the rise.

The three most important stocks in the group are Duke Energy (NYSE: DUK), Southern Company (NYSE: SO) and Dominion Resources (NYSE: D). The three companies together make up nearly a quarter of the S&P utility sector, and all three have experienced significant selling in the last few weeks.

In addition to the alarming price action, there has also been a significant increase in volume. This indicates that the selling is coming not only from individual investors, but also from large institutional firms such as mutual funds and pension programs.

Since these large institutions have large allocations to the utility sector, and because it takes these firms a significant amount of time to shift allocations, the selling in the utility sector will likely continue for a number of weeks (if not months).

The key takeaway here is to reduce your exposure to utility socks quickly in order to avoid further losses. There are plenty of opportunistic areas in the market to invest in, but the utility sector should be avoided at all costs.

With that said, I DO have an opportunity for you to make a significant profit with an aggressive bearish trade for this sector…

Double Your Money With This Bearish Utility Play

In reviewing the three major utility companies, Southern Company looks like it has the most risk.

As you can see in the chart below, the company’s revenues and earnings are not experiencing growth – and in fact, the revenue has been declining on balance for the last several years.

More disturbing is the sudden drop in profit margins over the last quarter. Obviously the company experiences an annual cyclical pattern. But this year, the drop in profit margins hit a new record low (while at the same time, the stock price has been trading near 52-week highs).

This divergence can’t last long… A company can’t continue to post poor fundamental results and have the stock price continue to climb. One of the two factors (price or profit margins) has to shift.

In this case, it is clear that the price is falling in response to broad market pressures and also due to the poor fundamentals of the company.

Over the last two months, analysts have begun to revise their expectations lower. This is another bearish factor for the stock, as lower analyst expectations tend to erode investor confidence.

In the next few weeks, I expect shares of Southern Company to trade sharply lower, with an initial target of $42 (near the support area from November 2012). The good news is that aggressive traders can make a tremendous return as this stock drops.

Consider the Southern Company August $46 puts.

If the stock trades down to $42 over the next two months, these puts will rise to a price of $4 per share – more than doubling your investment from current prices.

Of course, if Southern Company continues to drop below $42, the put position will realize an even larger profit.

Bottom Line: Utilities Are No Longer Safe

The key point here is that the utility sector is no longer a safe place for “widows and orphans” (or any other conservative investor).

As the Fed backs off its aggressive asset buying program, capital will continue to flow out of this sector, driving stock prices lower.

At some point, these prices will hit an attractive level where the dividend yield and potential for rebound gives us a worthwhile investment. But for today, you should avoid this sector and reduce or liquidate any exposure to the area.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of Wall Street analysts.

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