Despite "Valuation Hawks", Utilities Continue To Be The Market Leader
EPB Macro Research
Utilities (XLU) continue to surge ahead, rising over 30% over the past 19 months since the turn in direction of global growth. Despite the massive profits that could have been made in the utility sector over the past year, consensus opinion and more specifically, "valuation hawks", regard this sector as a bad investment, steering investors into less profitable investments.
Valuations are important for long-term performance. The valuation, however, especially when using a 1-year forward PE ratio, has virtually no impact on the medium term as the data clearly shows. Utilities have been "expensive" for months yet the sector has returned over 30% in 19 months, far from a "short-term" trade.
Staying away from this sector, at a time when global economic data supported an overweight position, likely caused underperformance and was clearly a massively missed opportunity to make several years of gains in one defensive sector.
For those that either subscribe to EPB Macro Research or have been following my work for a number of years know that I have been highly bullish of utilities for a long time, initiating a long position back in May 2018 (alongside a short position in regional banks). This position was initiated on the basis of slowing growth expectations and faltering inflation expectations, two conditions that drive nearly all asset classes and easily trump "valuation" over 12-36 month time horizons. The most important factor for your portfolio and your investment choices is the trending direction of the economic cycle.
In a recent note on why cycles matter, which you can read by clicking here, I highlighted seven "up cycles" and seven "down cycles," the seventh which we are currently still in as outlined by the data below.
The cycles, defined using the IHS Markit Global PMI and several factors such as the length of the decline, the magnitude of the decline and the breadth of the decline are outlined in the chart below. Down cycles are from points A to B and up cycles are from points B to A.
We can test the performance of various assets as we did in the previous research note during each up cycle and each down cycle. The results are overwhelmingly clear.
During up cycles, or when growth is accelerating, utilities rise in value on average but dramatically underperform more risk-sensitive assets. During down cycles, the current regime, utilities have an average return of 9.20%.
The chart below shows the excess performance of utilities compared to the S&P 500 during up cycles and down cycles. Up cycles are the top half of the table and down cycles are shown in the bottom half of the table.
As the table clearly highlights, during up cycles, utilities underperform the S&P 500 by 19% on average.
During down cycles, utilities have an average outperformance of 16% over the S&P 500 and a median outperformance of 20.3%, exactly in line with today's outperformance. The performance of utilities is not an outlier relative to history.
If growth inflected higher, would we still maintain a bullish position on utilities? Of course not.
The bullishness on this sector does not come from a dogmatic bearish view on the market but rather a historical analysis of sector performance during economic cycles. If the data changes, which we'd spot with a combination of long leading and short leading indicators, the outlook and positioning would change accordingly.
The data clearly shows that when growth is slowing, utilities are a far better sector to be invested in compared to the S&P 500 or other risk-sensitive assets.
Using the economic cycle, you could massively outperform the broader market and end up with three, four or five times more money by using both up cycles and down cycles to your advantage.
The true beauty of using economic cycles is that they are long-lasting so every type of investor can benefit from the economy's predictable rhythm.
Short-term growth rate cycles, not to be confused with business cycles, don't last a few days or a few months, they last several quarters or 1.5 years on average so there is no need to shift your allocation on a frequent basis. Utilities have been a sound investment based on the economic cycle for well over a year - not a short-term trade.
Shifting your portfolio mix every two years is far from a high-frequency trader and something that even long-term 401k investors can apply to their investing strategy.
Let's address valuation for a moment.
Although the valuation argument is clearly trumped by the economic cycle, let's have another look from a new angle.
The chart below shows the relative PE ratio of the utility sector vs. the S&P 500, compared to global PMI (inverted in the chart).
What this chart very clearly illustrates is that as growth slows, utilities get more valuable. This makes sense. Utilities have a predictable cash flow stream that gets priced at a premium when growth is slowing, uncertainty rises, and inflation expectations fall due to weakening growth.
Valuation is never a catalyst.
Will the valuation of utilities eventually matter? Of course. When growth inflects higher, the valuation of utilities relative to the broader market will more than likely decline and the valuation hawks will rejoice. Until that time, however, waiting for a mean reversion in valuation will be virtually entirely dependent on the forward trajectory of growth and inflation, something we use leading indicators to forecast.
Furthermore, as noted above, when inflation expectations decline, that is additional fuel for utilities over other assets.
The chart below takes the relative performance of SPY over XLU and the 5-year breakeven inflation rate. This chart shows a clear correlation between inflation expectations falling and utilities performing better than the S&P 500 (SPY).
This data proves that valuation alone is an insufficient factor to invest upon. The trending direction of growth and inflation are the major factors driving the relative performance between various assets including stocks, bonds, commodities and the dispersion within sectors.
If you want to get into the most profitable sectors, outperform the market, and ride the economic cycle, which you can often do for upwards of a year at a time, you need to have a process to identify the inflection points in economic growth and inflation.
Forecasting economic inflection points can be done by monitoring baskets of economic data that both logically lead in the economic sequence and have empirically led the economic cycle throughout history.
At EPB Macro Research, in addition to studying secular economic trends and business cycle trends, we are hyper-focused on the short-term growth rate cycle or the 12-36 month fluctuations in growth that drive the majority of your investing returns.
When analyzing these shorter-term cycles, we use a combination/confirmation process of several leading indicators, separated into two baskets: longer leading data and shorter leading data.
Longer leading data turns as much as 12-18 months before cycle turning points, followed by shorter leading data with moves that can be 6-8 months before downturns and 3-4 months prior to upturns.
By measuring long leading data, and having it confirmed by short-leading data, a high level of conviction can be gained before a cycle turning point and a pivot in asset allocation.
The long leading indicator graphed below, one of several long leads we use, outlined this current down cycle over 12 months in advance of its inflection point.
It is common to have a fear of missing out on an equity market rally. During a down cycle, the broad market can still rise which sucks in many investors without regard for the risk of the cycle. There are assets that rise with regularity during down cycles so there is no fear of missing out.
The easiest way to use the leading indicator process is to be long of cyclical equities during up cycles and shift to overweight bonds and defensive equities (such as utilities) during down cycles. It also makes logical sense and can be done in both tactical accounts and your more long-only passive accounts. Aggressive during up cycles and defensive during down cycles.
Knowing the direction of the economic cycle is the best way to maximize your upside and minimize your downside risk. The biggest risk to your portfolio always happens when you are on the wrong side of the cycle.
Having a process that involves long leading, short leading, and coincident economic data, coupled with the historical sectoral analysis during each cycle of growth and inflation will help to dramatically improve your investing results and greatly improve the conviction in your portfolio.
The performance of utilities over the next several months will be dependent on the trajectory of growth and inflation rather than valuation. If growth continues to slow, the premium investors will pay for utilities over the broader market will likely continue to rise.
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