Submitted by
Investing
Daily
as part of our
contributors program
.
In a typical year,
utility stocks
rally hard in the fourth quarter. In fact, the Dow Jones Utility
Average has finished the final three months of the year in the
black 36 times since 1969.
Utilities' fourth-quarter seasonal strength basically reflects
big investors' desire to lock in gains by loading up on more
conservative, dividend-paying companies. And the action is
typically reversed in the first weeks of the New Year, as money
again seeks out more adventurous places.
Only in truly unusual years have utilities failed to rally in
the fourth quarter. The crash of 2008 is one such example.
Utilities also retreated in both 2001 and 2002, when the sector was
suffering its worst bear market in a generation in the wake of
Enron's collapse. And they fell back in the fall of 1993 as well,
as the fear of industry deregulation ignited panic.
And 2012 proved to be another exception to the rule of utility
fourth-quarter rallies. As per usual, the sector was weaker in the
first quarter of the year, following a strong fourth-quarter 2011
rally.
By summer, utilities had strengthened, but by mid-October they
were dropping again. The final fourth-quarter damage to the Dow
Jones Utility Average (DJUA) was a drop of about 5 percent, or
roughly 3.8 percent including dividends paid, though the sector was
slightly in the black for the entire year.
Why did utilities fail to rally during the fourth quarter? There
are several likely explanations. Worries about the impact of sudden
austerity on the US economy-due to the so-called "fiscal cliff"-had
gained steam.
Exelon Corp
(
EXC
), one of the DJUA's larger components, dropped 16.4 percent during
the quarter on still unresolved concerns about its dividend. And
there was considerable uncertainty about what dividend taxes would
be in 2013.
The more interesting question for investors now, however, is why
utilities are rallying thus far in the New Year-a time when they've
historically suffered from seasonal weakness.
Calming Fears
Clearly, three trading days do not make a trend. But on Jan. 2,
the sector had one of its best opening days ever, closing at a high
of nearly 462. That followed a New Year's Eve rally beginning at
just over 443, and the group has tacked on modest gains the past
two days as well.
One obvious reason for the rally is the partial resolution of
Washington's budget battle. Utility stocks did not rally
immediately when President Bush cut the tax on dividends from a top
rate of 39.6 percent to just 15 percent in 2003. Consequently,
there was no logical reason for the sector-or any other
dividend-paying stock group-to decline if tax rates rose.
There was, however, undeniably some selling of dividend-paying
stocks in the year's waning months due to fears that higher taxes
would trigger selling. And utility stocks were caught right in the
middle of it.
As it turned out, the tax portion of the budget battle turned
out to be a major victory for income investors. The top rate did
rise to 20 percent, or 23.8 percent including the new surtax to
fund President Obama's healthcare law. But it only kicks in for
income of more than $400,000 for individuals and $450,000 for
couples.
All dividend income below that threshold will continue to be
taxed at the same rate as under 2012 rules. That's a sliding scale
of between 5 percent and 15 percent, again depending on the
relevant tax bracket.
Unlike the 2003 Act, there's no sunset on this law. Unless and
until there's legislation to change them, these are the tax rates
for dividend income. And dividend income is now also at permanent
parity with capital gains on tax rates. That's also a huge win for
utilities, which had lobbied hard for dividends to stay on an even
playing field as a way to encourage long-term investing.
As is the case for the rest of the stock market, utilities' New
Year rally also reflects relief that the most severe provisions of
the Budget Control Act of 2011 will not come to pass. Many
economists had forecast a hit to gross domestic product (
GDP
) of as much as 4 percentage points, had the full package of $600
billion in automatic tax increases and spending cuts actually gone
through.
As they proved in 2008, utilities would have fared far better
than most businesses, had such sudden austerity tipped the economy
into recession. Sector stocks, however, would likely have suffered
in the near term due to uncertainty. Mainly, no one really knows
how many dollars would be lost in the private sector per dollar of
federal spending cuts/tax increases. And until that question was
answered, fear would have run rampant.
The passing of what could have been a major blow to the US
economy is no doubt a good reason for relief. And the good times
could well extend if other economic news continues to improve, both
in the US and in Asia, where industrial output is again
accelerating.
In addition, utility stocks on the whole are a value in this
market. The DJUA is still more than 90 points below the all-time
high of about 555 reached back on Jan. 8, 2008. That's in part
because of the sharp drop in Exelon, which has suffered from the
decline in wholesale electricity prices. But it's also in spite of
continued robust dividend growth for most of the other stocks in
the index.
Beware the Headwinds
That too suggests further upside for utility stocks going
forward, in addition to safe and generous dividends. There are,
however, headwinds that could put the brakes on this rally and
depress returns the rest of the year.
For one thing, the budget compromise passed by Congress and
signed by the president last week is still the most contractionary
fiscal action by the federal government in decades. Counting the
spending cuts that are likely in the coming months as the rest of
the budget battle plays out, US austerity measures amount to 1.9
percent of GDP. That's more than the UK, France or Spain is
currently doing, and all three of those countries are currently
mired in recession.
Front and center is the end of the so-called "payroll tax
holiday," which means Social Security tax rates will now rise by
two percentage points. That's a tax increase that affects almost
every American. And it will arguably have a far greater percentage
impact on middle class disposable income than higher income tax
rates will have on wealthier Americans.
Even meeting the 0.7 percent annual growth in US electricity
demand currently predicted by the US Energy Information
Administration will require an enormous capital outlay by power
companies in coming years. And that's not including spending needed
to upgrade transmission and distribution systems to meet
ever-rising standards for reliability, or for compliance with
environmental regulations.
Utilities that can capture a fair return on that spending rate
are among the surest investments in the world. Capital spending
will flow right to rate base, and from there to earnings, dividends
and share prices in coming years.
On the other hand, utilities that are unable to earn a fair
return will suffer, just as they did following the capital spending
boom in the 1970s. And though most management teams are playing
things very conservatively this time around, it is possible we will
see dividend cuts and even bankruptcies in extreme cases.
The linchpin is companies' relationship with regulators. And
thus far in this building cycle, most states have been supportive.
So has the federal government, which continues to grant generous
and stable returns on equity for investment in badly needed
transmission infrastructure.
The danger is if austerity worsens Americans' economic plight
enough to fracture the current utility/regulator compact. And to be
sure, we've already seen some trouble signs, such as the bashing of
utilities' Hurricane Sandy response by certain Northeast
politicians.
Many investors consider owning exchange-traded funds (
ETF
) as the best way to play sectors. And there are certainly options
for a sector as widely owned and highly capitalized as utilities.
Utility HOLDRs Trust
(OTC: UTHYL), for example, is an ETF that tracks the Philadelphia
Utility Index-a large-cap index that holds most of the components
of the DJUA.
The quality of regulation, however, has historically varied
widely between individual states. And while some states can be
viewed as reliable supporters of investment, others simply aren't.
Moreover, while a majority of power utilities are at least mostly
regulated, some like Exelon are exposed to the vagaries of
wholesale power prices.
The bottom line is whatever the popular delusion, utility stocks
are definitely not equal as investments. Some are truly destined
for greatness going forward and you'll get them if you buy an ETF.
But you'll also get the sector's bad and ugly. And if austerity
really does dampen the economy in 2013, they definitely won't fare
well.
That makes individual stock selection as critical for the
utility sector as for any other. And come what may for federal
negotiations on the debt ceiling and government spending this
spring, those differences and distinctions will only become more
important as the year goes on
.
For 5 dividend-paying picks that should do well in 2013, see our
free report on the
Top 5 Dividend-Paying Companies
.
This article by Roger Conrad was originally published on
Investing Daily under the title:
Utilities' New Year Rally: Will It Last?