The Predictive Power of Utility Stocks
Technical analysis, which looks to forecast the future direction of asset prices by exploiting past market data, has been the subject of extensive research and rigorous debate over the years. And there is no shortage of skeptics when it comes to the efficacy of the investing discipline. Warren Buffett once said, “I realized technical analysis didn’t work when I turned the charts upside down and didn’t get a different answer.” But investing anomalies like the Halloween Indicator, popularized by the adage, “Sell in May and go away,” suggest that there are some technical strategies that may confer an advantage to their adherents.
Utility stocks have previously been identified as leading indicators for broad stock market movements, and new research from Charles Bilello and Michael Gayed, CFA, not only confirms the predictive power of utility stocks but also puts it to work in a fairly simple strategy which rotates into and out of utility stocks based on the relative strength of the sector. Besides forming the basis of a so-called “beta rotation strategy” (BRS) that yields compelling risk-adjusted returns over time, the authors note that utility stocks also provide important signals about increased volatility and extreme market moves. In recognition of their work, Bilello and Gayed received the 2014 Charles H. Dow Award from the Market Technicians Association.
Utility stocks’ uniqueness is owed in large part to their capital intensive nature, their relatively high debt levels, and their sensitivity to interest rates, which became more pronounced with the passage of the Public Utility Holding Company Act of 1935. This law served to limit rate increases and speculative investments on the part of utility companies, tying their earnings even more closely to interest rate movements. Utility stocks have been found to outperform the broad market when rates are falling and underperform when rate are rising.
In their study, Bilello and Gayed examined pricing data going back to 1926 and developed a trading strategy whereby they would invest the entire portfolio in the low-beta utilities sector for a week when that sector exhibited positive relative strength over the prior four-week period. When utilities’ four-week relative strength turned negative, they would move assets to a broad market portfolio. Their BRS delivered a 13.9% annualized return versus a 9.8% return for the broad market. The outperformance was remarkably persistent, as the BRS beat the market in 82% of rolling three-year periods observed. Risk-adjusted returns were also superior across time periods.
Importantly, Bilello and Gayed acknowledge that transaction costs would have made such an active trading strategy prohibitively expensive over much of the time period tested. Now, however, they can execute the strategy cheaply, at least in tax-deferred accounts, through the use of ETFs. Even more valuable than the prospective returns offered by the BRS may be the volatility signal it offers to investors. The authors found that leadership by the utilities sector tends to precede periods of high market volatility, corrections, and extreme market drawdowns. Between January 1990 and July 2013, the BRS was positioned in utility stocks 83% of the time when the top 1% of Chicago Board Options Exchange Market Volatility Index (VIX) values were observed, suggesting that all investors may benefit from paying attention to how utility stocks are behaving.
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