Utility stocks had a pretty good year in 2019, where they actually kept up with the market. 2020 hasn’t been very kind, but Goldman Sachs wants us to buck the current trend.
Even though the utility sector isn’t really that competitive overall, we always look to view each situation according to its current merits, and even a fairly dead sector such as utilities can have its moment in the sun.
The claim to fame normally with this type of stock isn’t the fact that their dividends are higher than your normal stock, it is that these stocks generally have less risk to the downside, which does have its place with certain investors at least.
The proper and efficient way to manage downside risk is to just avoid it, not use preemptive strategies such as holding lower beta stocks just in case we get a crash. Perhaps oddly, but not so much if you understand the prevailing mentality of most investors who refuse to step up and take the more active role that managing your investments require, managing your investments actively is not very popular, and we choose to instead expose ourselves to a lot more risk than we should, and come up with workarounds to lower the cost of this mistake.
It doesn’t do any good to tell investors to get too far out of their comfort zone though, and while we may be very comfortable with going with higher beta stocks and be confident that we will only stick around while the weather remains good, and seek shelter when it is wise to do so, a lot of investors struggle with this.
Managing risk has to be practical, and if you advise someone to do it a certain way and they can’t bring themselves to do it, if you don’t at least try to give them something that they can’t handle that is at least an improvement over what they are doing now, you have missed an opportunity to help them.
We therefore spoke on the desirability of the utility sector for those who find themselves in this boat, and while the hope still is that they will see the error of their ways and develop a more informed and mature understanding of how to manage risk, and both know what the right thing to do is and have the courage to put the plan into action.
When we do see a situation where a plan such as investing in utilities provides at least close to competitive returns while still providing investors who have handicapped themselves with their desired lower drawdowns, we have no problem recommending such a plan, as we did during this sector’s surprisingly good performance in 2019.
When a sector goes up close to what the S&P 500 does, with just a third of the drawdown risk, such a thing does have its place as long as it continues. Such a thing can be of practical interest to a particular type of investor, one fairly close to taking money out of their portfolios, or actively withdrawing now, together with a refusal to manage this risk otherwise, by simply setting a tolerance level for drawdowns and then step away when that is exceeded.
This is not unlike how we accommodate physically handicapped persons, where we may build a regular door that able people can use but should not forget about those in wheelchairs who will need special accommodation to be able to enter. We even went as far as to suggest that these investors putting all of their money into the utility sector may not be a bad idea under normal circumstances at least, but every plan has its conditions and even the most stubborn investors cannot afford to bar the door to change completely, and change has certainly come with this plan.
Compared to the S&P 500, the Utilities Select Sector SPDR fund has done surprisingly well in comparison over the last 10 years, only coming in a couple of percentage points lower in terms of return, and have matched the big index over the last 5. If you favor the S&P 500, which we don’t but many investors do, and you are not comfortable with spicier indexes such as the Technology Select Sector SPDR ETF, and you desire drawdowns that are only a third what the S&P 500 incurs, the return to drawdown ratio of utilities, at least compared to the big index, can look pretty good indeed.
Using beta, the tendency of a stock or sector to lose value compared to what the S&P 500 typically loses, is not something that investors generally have to focus on, as drawdown only matters when you are close to needing to get out, and if we don’t need to sell soon, we should not be worrying about the zigs down the mountain on our way to the top as long as we are moving in the right direction. It’s where we end up that matters, at the time where we are looking to cash in these investments.
However, drawdown risk does matter if you are an older investor, insist on holding through bear markets, and therefore exposed to be cashing in during a bigger pullback. This indeed is accommodating the handicapped, as the better approach would be to manage risk more tightly under these conditions and get out of your positions when you are closer to cashing in and protect your profits more, but few of these older investors are willing to do that, instead following the bad advice of holding fast and taking the beating.
If you are getting ready to cash in and you somehow managed to hold your stocks through the recent crash, no one should have done that and especially those who need to manage their drawdowns. If you didn’t understand we were in real trouble for a while when this first hit, you really shouldn’t be in stocks, no more than people should continue to drive their cars when their vision fails.
Even with positions such as being in utilities, where we might look to build our houses of stronger wood, nothing is so strong to stand up to a major hurricane, of a strength that there is only one way to protect yourself, which is to do what people usually do when hurricanes come, run for cover.
This is not unlike facing two potential opponents on the street, where you are told that you can fight a big guy or an even bigger guy or run away, and you choose to fight the smaller of the two who will lay less of a beating on you. You are told to man up here, so much that doing the smart thing, not choosing to fight when you are at a big disadvantage, doesn’t even come up much, and when it does, you push these thoughts away as this is not how a real man invests presumably.
When the Real Bears Come, They May Find You Regardless
If people insist on doing this, choosing to trade blows with a bear while riding the utility index, we need to realize that even if this strategy works, we’re going to take some real blows regardless, especially from real bears, the kind that scare us into this type of stock in the first place.
Early on in the crash of early 2020, even on the first day of it, the amount of selling that hit this index told us that this was not an investment we wanted to be in during this time. The utility index just didn’t take its normal one third share of drawdown, it was taking the full blow, where we thought we were fighting Pee Wee Herman but Mike Tyson took his place and threw some heavy punches right from day 1.
We had a look at this chart and it wasn’t hard to tell that we were in for a real tumble, and the utilities index ended up dropping 39% during this brief crash, even more than the S&P 500, the Nasdaq, and even the tech sector ETF did.
This left those who believe the fairy tale that stocks move according to changing business conditions really scratching their head, and they scratch their head a lot but never hard enough to wake their brains up to see through this illusion, which isn’t even up to the level of illusion because this sort of thing doesn’t even manifest itself at all, it is just assumed to exist and then people just believe.
This therefore isn’t a matter of looking at the data and misinterpreting it, which we could call being guided by illusion, we get here by not bothering to look at all, which qualifies instead as a delusion. In any case, utilities are known to have the most stable businesses of anyone, and while people may not have been able to make their rent or mortgage payments, utilities get paid first at the worst of times, even before we buy enough food, and we can’t even store or cook our food without utility service.
People believe this and usually trade these stocks accordingly, not getting worried so much during a big pullback, although it is imperative that we understand that it is this belief and this belief alone that provides this margin of safety. We just found out what happens when this belief is not maintained, as it has not been during this recent fall.
This is all about supply and demand, and the moment that this sector started to fall, those of us who understand stock prices this way, the right way, saw that the supply and demand dynamic with this type of stock alter markedly, in a way that was very concerning and more than enough to wish to run away and perhaps not come back for a long time.
Utility stocks have kept up pretty well over the last 10 years because the market took a competitively bullish outlook on them. The moment that this turned so bearish, that was the tipping point, where it took not just the first couple of inches of the knife but the entire blade, cutting through their better body armor like going through butter, and with this armor no longer protecting us, we are left with these lesser returns and the full damage when things turn sour, something that no one should ever want.
The single reason why anyone would want to invest in utility stocks is for their very low beta. Beta ratios are most valuable when viewed dynamically though, watching how this number changes to at least check whether this is holding up or things have changed enough to make this not only not a desirable characteristic but one that may bode very poorly as far as its outlook goes.
If we see the S&P 500, with a beta of 1 since this is the benchmark, drop by 34%, and we see the tech sector ETF, which has a beta around 1 as well, also drop by 34%, which is what happened, this is a normal event that we would expect. From there, we’d expect that the tech sector, which has a higher alpha which means it grows faster than the benchmark when things are moving up, to well outperform the big index as it usually does once things pick up, which it did.
If your beta is only a third of the S&P 500 but you are moving down faster than it does during a move, that’s a critical change and a single day of this was enough to sound all the alarms and run for your life. It’s 39% drop wasn’t that much bigger than these other two, but the fact that this isn’t supposed to happen is the concern, and a massive one.
There’s an easy explanation for how this could happen, and it has nothing to do with the utilities themselves, but rather with a major change in the demand for these stocks, where the market decided to have them considerably more out of favor than we would have expected given their past performance. There’s no need to even ask why as King Market does what it wants and it matters not what the reasons are.
When COVID-19 Hit, It Was Time to Turn Off the Utilities
Many pretend that the market doesn’t play a role at all in stock prices, as ridiculous as that is, and just ignore such things, looking at this beaten sector and believing that it took way more of a hit than their analyses indicates, mistakenly believing that their analyses even looks at the right things.
Just like energy stocks have been out of favor for years, and financials have fallen so much out of favor since the pandemic hit, the degree that a stock or group of stocks are in or out of favor not only matters, it’s actually the only thing that matters. We ignore this at our peril.
We hope that investors were able to get out of their utility positions without suffering too much harm, but we know that a lot of people have just hung on to them, still treating them like they are very low beta even though that has most certainly changed now. It doesn’t matter if they will return to their lower beta now, as if you are investing based upon this one thing and it collapses on you, you will pay the full price of this mistake if you insist on living in the past so much and ignore the present so much.
Like with other types of stocks, utility stocks have come back from their lows, and did offer a rebound play, but not one that was that competitive with other types of plays. Their rebound paled greatly in comparison with the tech sector, which not only recovered all of its losses but has gained an additional 11% from its previous high before stocks got smashed.
The utility index is still 16% away from where they were before all this started, during a time where many believe the recovery has overshot somewhat, even allowing some sectors such as industrials and materials which have been lagging the market to rebound much further than anyone would have thought given the current economy.
If utilities were to rise up off the mat as far as we would want, we would think that this would have happened already, which makes recommendations like Goldman Sachs now being bullish on this sector really look strange.
They are making the usual mistake of looking at business fundamentals far too much though, and if this really mattered, utilities would not have taken anywhere near the blow they did nor would their recovery be so restrained.
Goldman Sachs also speaks of the even more attractive dividends that utilities pay, and the fact that investment professionals can be fooled by this as well should disturb us, although this happens all the time and we would be surprised if we actually did see them getting their heads straighter about this, and understand that total returns actually involve both dividends and price movement.
We cannot even fathom how anyone gets fooled by this in fact, as it requires an epic level of ignorance, enough to somehow turn away from how changing asset prices affects our market valuation. Closing your eyes to such a thing is even inconceivable, but is nonetheless widespread, even among analysts working for a major investment bank. If these folks commit this egregious and even unbelievable mistake, this shows just how much of a pandemic of confusion we have on our hands.
Goldman Sachs does rely on a more sophisticated red herring though, where they are looking at the spread between utility yields and treasury yields and have found that utilities tend to perform better following such a divergence, but these are far from normal times. This assumption has already proved invalid for this current move, as this yield spread has already been wider from front to back with it, but utilities have far from outperformed the market.
At the very least, we need utilities to come back more into favor, to actually show us that they can outperform. Until they do, it is foolish to chase the past when the past has been shown to not apply right now, and take a flyer on it anyway.
The performance of the utility sector has now put them in the bottom three of the 10 major sectors in the S&P 500, only now better than energy and financials. The energy sector continues to be the best way to lose money, but at least the financial sector has more potential for recovery, even though these stocks will need to come back into favor more first before we should ever want to jump on board that train, which is stuck in the station like utilities right now.
Utilities just don’t have the upside to be competitive enough right now, where their couple of percent extra in dividends that they earn only goes so far, and they at least need to get within something close to that in terms of price performance to really compete. If this extra 2% gets put up against being behind by as much as 26% on the price side, in comparison to the tech sector, that still leaves us with a net comparative loss of 24%. With competing investments looking more, not less bullish going forward, the gap probably won’t be narrowed, it should continue to widen.
Utility stocks may come back into style one day, but that day is not today nor is even on the horizon right now. The infection that COVID visited on them still has them pretty sick, and we should avoid sick stocks and look more toward those who are more well, which is the only advise people need if they are considering taking a flyer on them right now like Goldman Sachs is recommending.