Are Utilities Set for a Second-Half Run?

Perhaps one of the most overlooked sectors in the S&P 500, utilities have performed well in 2024. As of this writing, the group is up almost 15% so far this year, the third-best performing sector in the S&P 500 — only behind technology and communications, which are up 22% and 19.7%, respectively.

Investors generally flock to stocks and industries that they know well and use often, and while most consumers use the services of a utilities firm on a daily basis, it’s an easy group to overlook.

Here’s why that may change in the second half.

Playing Offense

Generally considered a defensive holding for its stable cash flows and steady income, that’s not what’s driving utilities higher in 2024. Instead, investors are leaning into other narratives like earnings growth, rate-cut expectations, and artificial intelligence. Yes, AI.

It’s no surprise that rate-sensitive assets like utilities and real estate struggled to start the year. Coming into 2024, the market was pricing in upwards of six rate cuts from the Federal Reserve. Those expectations swung all the way to zero at one point and now the pendulum seems to be balancing out closer to two cuts.

Regardless of the final tally, the expectation is that rates will be lower in the next few quarters and the Fed has made it clear that a rate hike is off the table — making rate-sensitive and dividend-oriented assets more attractive.

But even without rate cuts, this group has momentum.

In 2024, the group is forecast to generate earnings growth of 10.8%. If achieved, it will mark the sector’s best year of growth since 2009. That growth number may not be as attractive if the valuation were too high, but in this case, it’s less of a concern (more on this in a moment).

When it comes to AI, this is an exciting talking point — regardless of whether we’re talking about Nvidia or utilities. At the end of the day, AI applications are large power consumers and those power needs will be filled by utilities.

Bulls want to be careful not to put too much weight into this, but it’s acting like a cherry-on-top type of catalyst right now.

The valuation is reasonable

The sector currently trades at about 17 times the next 12 months of forecasted earnings. That’s below the roughly 21x forward multiple that the S&P 500 trades at, and more importantly, utilities trade at a reasonable valuation on a relative basis.

The sector’s forward price-to-earnings ratio has bounced between 15 and 21 since 2017, and with a median forward P/E ratio of 17.9, utilities don’t appear overly expensive — particularly given the current growth expectations.

Additionally, utilities trade at just 15x their 24-month forward P/E, down slightly from a year ago and down notably from 19.4x in January 2020 before the pandemic.

Lastly, just 28% of utilities stocks are trading above their 2015 to 2019 median forward P/E ratio. That’s down from 38% in May and down from roughly 90% in January 2020. For the sake of comparison, that’s the third-lowest among S&P 500 sectors (above only energy and communications) and compares to almost 50% for the overall index.

A pullback was in order

While the list of positives is notably longer than usual for this group, the recent dip was well-deserved. The XLU ETF rallied 16.5% from its mid-April low to mid-May high, climbing in five straight weeks and vaulting it toward the top of this year’s list of best-performing sectors.

The ETF had given up about half of those gains over the ensuing six weeks into the end of Q2. July has been a strong start for the group, igniting with a fresh breakout on renewed rate-cut hopes from the Fed.

For the upcoming earnings season, Q2 earnings are expected to be disappointing for utilities. The sector is working off three straight quarters of double-digit earnings growth, but for Q2, consensus expectations call for growth just 1.4%.

That could lead to some bumpiness in the short term, but for longer term bulls, this could be a good thing.

While Q2 earnings expectations take a breather in the upcoming quarter, remember that guidance will key. That’s particularly true with earnings forecast to accelerate — albeit in a somewhat bumpy manner — over the next five quarters. Estimates call for Q3 growth of 7.7%, followed by growth of 8.5%, 3.8%, 11.7%, and 9.4% in the following four quarters, respectively.

If this growth comes to fruition, it could act as a bullish catalyst for longer term investors.

The bottom line

Utilities are often an overlooked sector in the market, with a long list of favorites ahead of it. But that tide could be shifting — albeit quietly — with the number of positives working in this group’s favor.

Chief among them is a solid earnings growth outlook, combined with a relatively low valuation and the expectation for lower rates. Throw in a 3.1% dividend yield for the XLU and an exciting talking point with AI, and this sector could be ripe for more gains in the second half of 2024.

The risk here is straightforward, too.

After all, estimates are just estimates, and if utility companies fail to live up to these expectations, the stock prices could move lower. The same is true if inflation comes roaring back to life (taking rate cuts off the table), although that doesn’t seem like a base-case scenario at the moment.

*Options may be one way for investors to participate in continued upside, particularly through the use of calls or call spreads. These types of options allow investors to speculate on potential upside, with the risk for buyers being limited to the price paid for the calls or call spreads.

For call buyers, it may be advantageous to make sure they have adequate time until the option’s expiration. On the flip side, investors who aren’t feeling so bullish or who are looking for a deeper pullback, puts or put spreads could be one way to take advantage.

*Options involve risk and are not suitable for all investors. Please review Characteristics and Risks of Standardized Options prior to engaging in options trading. In some rare instances, you may lose more than your initial investment.