Utilities ETFs Cool Off in a big Way

The Utilities Select Sector SPDR (NYSEArca: XLU) has spent significant time as one of this year’s best-performing sector exchange traded funds. Until recently, XLU was actually the best performer among the sector SPDR ETFs, but has since been usurped by the Energy Select Sector SPDR (NYSEArca: XLE), the largest equity-based energy exchange traded fund.

In just the past week, XLU has tumbled nearly 4% and some traders believe there could be more downside to come for once hot utilities stocks and ETFs.

The fortunes of the utilities sector seem to be tied to the Federal Reserve’s interest rate outlook. Once the Fed eventually hikes interest rates, the higher rates will make fixed-income instruments more attractive on a relative basis, and bond-like equities, like utilities, less enticing. Consequently, utilities may remain flat or underperform other segments of the equities market once rates start ticking higher.

Related: Will the Utilities ETF Sector Keep Shining?

XLU currently shows a 18.69 price-to-earnings and a 1.87 price-to-book. The S&P 500 Utilities Sector is showing a 12-month forward price-to-earnings ratio of 19, compared to its 10-year average of 14 and will above the PE of 16.4 for the broader index.

“In fact, the XLU has dropped 9 percent since the beginning of July, to its lowest in just over four months. The fall, according to Phillip Streible, senior market strategist at RJO Futures, can be attributed to what’s going on with the XLU’s two biggest components: electricity and natural gas stocks,” reports CNBC.

Looking ahead, FactSet projects the utilities sector is expected to experience earnings growth of 4.4% in 2016. Consequently, analysts warned that the lofty prices may not be supported by robust earnings growth.

The utilities sector is trading at heightened valuations after investors plunged into the defensive play in search of yield and safety in an environment of historically low yields, slow growth and geopolitical uncertainty.

Related: Surging Utilities ETFs

“According to Streible, electricity has recently been hit with more regulatory costs while natural gas rig counts have picked up as of late. Both could end up weighing even more on the utilities sector, especially ahead of a potential Federal Reserve rate hike in December,” reports CNBC.

For more information on defensive ETFs, visit our defensive ETF category.

Utilities Select Sector SPDR

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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