The combination of the utilities sector ranking as easily the best-performing sector this year, interest rates that appear to be remaining low for the foreseeable future and investors' overt preference for defensive sectors, it stands to reason that some market observers view utilities stocks as expensive.
That is often the case with utilities, a sector that historically trades at multiples above the broader market. It might also stand to reason that utilities exchange-traded funds adhering to momentum strategies or those heavy on small-caps would be pricey as well. Such ETFs include the PowerShares Dynamic Utilities (ETF) (NYSE:PUI) and the PowerShares S&P SmllCp Utlts Pfo (NASDAQ:PSCU).
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The S&P 500 Utilities Index recently topped a price-to-earnings ratio of 18.5, high even by the standards of a historically expensive group. Expectations that the Federal Reserve will be unable to raise interest rates this year have a lot to do with the multiple assigned to the utilities sector.
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Declining interest rates are typically a function of slow economic growth and relatively low rates of global inflation. Primarily meant to prime the economic pump, lower interest rates have also had the unintended result of increasing flows into the utility sector as investors have sought new sources of yield boosting P/E ratios in the process, according to PowerShares.
Honing In On PUI
PUI tracks the Dorsey Wright Utilities Technical Leaders Index, which is designed to identify companies that are showing relative strength (momentum), according to PowerShares, the fourth-largest ETF issuer.
PUI is arguably one of the more diverse utilities ETFs in terms of cap exposure. In fact, large-cap utilities account for just 27 percent of the fund's weight, roughly equivalent to the ETF's small-cap allocation. Mid-cap utilities are 45.6 percent of PUI's 34-stock lineup.
Still, it is all about interest rates for utilities stocks and ETFs. After all, the sector is the most negatively correlated to rising rates of any group.
Treasury yields and the P/E ratios for the S&P 500 Utilities Sector Index between 1990 and 2000 depicted by the blue dotted lines and the solid blue trend line. During this time, the 10-year Treasury yield also explained 75 percent of the variation in the utility sectors P/E ratio, added PowerShares. The same relationship after the 2008 financial crisis is illustrated by the red boxes and red trend line. Here the relationship is more linear and not as robust. Nonetheless, all three scatter plots support the idea that investors typically pay more for a stock when interest rates are low.
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