SAFT ON WEALTH-Utilities flashing red

Wed Apr 16, 2014 5:25pm EDT

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(James Saft is a Reuters columnist. The opinions expressed are his own.)

By James Saft

NEW YORK, April 16 (Reuters) - Utility share prices, a reliable leading indicator of stock market ructions, are flashing red.

Utilities have been particularly strong, especially relative to the broader market, a set up which has historically been a flag for relatively weak stock markets and high volatility.

The Dow Jones Utilities Index is up nearly 13 percent this year, compared to a fall of nearly 4.0 percent in the broader market. The divergence has been especially striking since early March, since when utilities have outperformed by nearly 12 percentage points.

"The fact that you are seeing this year utilities and long duration bonds performing so strongly is telling you that something is off - and when utilities lead it tends to happen before black swans strike," Michael Gayed of Pension Partners said in an interview.

"Utilities have been strong since the first week of January, signaling concern, alongside long-duration Treasuries for some time before the high momentum breakdown began," he said.

"We may be in a correction and, in fact, you are seeing action that indicates we are probably in a correction."

Gayed, whose paper on utilities, co-authored with colleague Charles Bilello recently was awarded the 2014 Charles H. Dow prize for technical analysis, has amassed decades of evidence of the predictive power of the sector. ( here )

Using market weighted total return data going back to 1926, they found that a strategy which positions either into utilities or the broad market depending on which is showing leadership (essentially momentum) can significantly outperform a buy and hold strategy of both.

The strategy is simple. When utilities show better relative strength than the broad market over the prior four weeks, position into utilities for the next week. When the broad market is stronger, do the reverse.

Between 1926 and 2013 this resulted in a four percentage point annual outperformance of a buy and hold strategy, taking an initial $10,000 investment to $877 million by 2013, against $34 million for the broad market and $17 million for utilities.

The strategy has outperformed the market in each decade and over 82 percent of all rolling three year periods.

VOLATILITY

Though the strategy is interesting, and the data compelling, in many ways the underlying story and the mechanics of utilities as a signal is the most valuable part of the study.

For one thing, putting such a strategy in place would have been prohibitively expensive for much of the past 88 years, though now it is easily practicable using exchange traded funds.

Most significant is the indication that utilities can be used as "a critical warning sign of higher average volatility to come in the market, and can be an early tell of whether the odds of an extreme tail event are rising," according to the paper.

Since 1963 average market volatility is 18 percent when utilities are leading versus 13.6 percent when utilities are lagging.

In those weeks since 1926 in which the stock market fell by more than 5.5 percent, utilities outperformed the broader market in the previous four weeks nearly 60 percent of the time.

During the periods experiencing the highest one percent readings of the VIX volatility index since 1990, utilities were showing relative strength 83.3 percent of the time.

Utilities are generally the most boring of stocks, steady dividend payers beloved of the proverbial orphans and widows.

That stability is a large part of why they offer predictive power. Utilities are extremely tightly regulated, both in terms of what they can charge and how they can expand. And because everyone wants the lights to turn on, they are more or less assured a steady, if narrow profit margin.

The biggest variable that can affect profitability, therefore, is the cost of capital. And because power plants are big and expensive, utilities are extremely capital intensive, requiring huge and ongoing investment. And because it takes so long to build and bring on-line new plants, that capital investment has a very long lead time and is more stable than in other industries.

Whereas an auto maker might expand rapidly in boom times, a utility needs to think in decades.

That stability and need for capital makes them the most bond-like of equity sectors. If demand for capital is going down, sending its cost down too, utilities will tend to outperform. A falling demand for capital is not a strong sign for the rest of the economy, and a rapid or sudden fall in demand can often come just before a market correction or spike in volatility.

To be sure, what has worked for 88 years may not work in future.

With plenty of other reasons to worry about stocks, the utilities signal, with its long track record, is one to take particularly seriously.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft) (James Saft)

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