ALLOCATIONS: Hot summer utilities rally cools -- for now

Oct 24 (Reuters) - Utility stocks, off the grid for many investors in the two years after the 2008 stock collapse, have become the hottest sector in the market this year.

The group is on a power surge since August, with 12 straight weeks of fund inflows that juiced an 11 percent year-to-date total return. In comparison, the Standard & Poor's 500 is roughly breakeven this year. Houston-based CenterPoint Energy even topped out at 34 percent year-to date to lead top performers.

But with a broader market rebound taking shape investors have cooled a bit, scaling back purchases to just $300 million in October, down from $1 billion in both August and September, according to funds data provider Lipper.

The slowdown in utility funds is hardly surprising after the longest streak of weekly inflows in seven years. The sector has been analysts' favorite group since May, based on estimate revisions and recommendations compiled by Starmine.

The utilities sector is not cheap, but investors look to be in no hurry to leave it.

"People are afraid to sell them, and I would not want to be underweight this group," said Dan Eggers, a utilities analyst at Credit Suisse.

THE MIDDLE GROUND

Analysts have been keen on dividend-paying stocks for more than a year. The move to dividends gained momentum this year as the average yield on Standard & Poor's drew even with bonds. Utilities, usually the top dividend-paying sector, pay about 4 percent -- topping government bonds and S&P yields, both hovering below 3 percent.

While utilities have trailed materials and industrials during the recent stocks rally, the utility sectors still holds attraction, especially for income-conscious investors not convinced about the strength of the recovery.

"Fears of a global economic slowdown haven't necessarily disappeared over the past week," said Brian Ullman, who manages about $254 million in funds for Fresno, California-based LPL Financial. "It might take until a deal in Europe is signed, sealed and delivered until these analysts change their preferences."

The utilities have been a safe haven during Europe's troubles. The total return of the State Street Select Sector Utilities SPDR to 11 percent year-to-date, while the S&P 500, even with dividends added, is slightly below breakeven.

To be sure, utilities don't provide the high level of safety of government bonds, and in the 2008 market collapse the sector suffered like the rest of the equity market and in the two years that followed they lagged. While the S&P 500 has climbed 180 percent since the 2009 lows, utilities are up just 150 percent. While inflows into bond funds exploded in the post-collapse period -- utilities did not benefit much.

EXCEPTIONAL PERFORMERS

But switched-on utilities have gone from ignored as too boring to being too hot for some investors to handle. Now, analysts say, the conversations have turned to, "how long can the run continue?"

Top-performing utilities include CenterPoint's 34 percent return; Oklahoma's gas utility OneOK , with a 31 percent total return; and NiSource , with a 30 percent total return.

There are reasons to wonder whether the sector will outperform. Dividend seekers bid them up as they fled cyclical groups in August and September. This has pushed utilities, which usually trade at a discount to the overall market, to an 18 percent premium over the S&P 500 based on a price-to-earnings multiple to 13.6 times forward earnings.

The high P/E might be justified if earnings growth were stronger. But analysts see utilities earnings falling 1 percent over the next 12 months, while S&P earnings should climb more than 12 percent.

THE PAYOUT MATTERS

But the growing appeal of the sector comes from the fact that nearly every other yield category has been picked over, and is not directly connected to earnings potential.

With the Federal Reserve committed to holding rates for nearly the next two years, analysts say utilities also will continue to hold attraction for fixed income investors. Eggers sees total annualized rates of returns for regulated utilities at 7 percent to 12 percent going out to 2014.

If the economy recovers, utilities have an even wider advantage of bonds, since companies providing power and water can generate more income and raise dividends in a rising economy. Bonds, meanwhile, would tend to lose value in a stronger economy.

Among individual stocks, Eggers recommends CMS Energy Corp . Analysts expect earnings growth of 6 percent faster than larger peers such as Dominion Resources and Consolidated Edison and it could rise 10 percent to 15 percent next year.

Brian Chin, who heads Citigroup's North American utilities research, sees some selective buys, including Exelon Corp , with a 5 percent dividend yield. Earnings and revenue growth are expected to decline in the next 12 months. He says its agreed merger with Constellation Energy makes sense and is likely to win approval.

Chin is still bullish on the group, but advises clients to pay attention to valuations, and not just to the fattest dividend yield.

"I still expect another 8 to 10 percent upside in the next 12 months, but this is not a sector where you want to dive in face first," Chin said.