Are Utility Stocks In A Bubble That's About To Pop?

Utility stocks pay some of the safest dividends around and typically sport much higher dividend yields than the market, reflecting their low growth prospects and making them a favorite source of income for retirees living off dividends.

Many dividend investors wonder if favorite utility stocks like DUK, NGG, NEE, D, and SO are in a bubble today after benefiting from extremely low interest rates for more than six years. Utilities were clobbered on Friday after strong employment data strengthened the likelihood that the Fed would raise interest rates next month for the first time since mid-2006.

The fear is that many investors flooded into higher yielding stocks like utilities because they could not earn enough safe income from the very low yields bonds offer today (see below). Once bond yields begin to rise as the Fed gradually raises its target interest rate, these investors might sell their stocks to purchase bonds.

Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis

As seen below, we have been living in unprecedented times over the last seven years, with the Fed’s target interest rate remaining just above zero percent. It has never been this low for this long before, so there is plenty of uncertainty regarding how an eventual interest rate increase, as early as December, will impact markets and yield-sensitive sectors like utilities. Have these safe haven sectors been artificially inflated by the Fed’s easy money policy? Will they pop when interest rates begin to rise?

Source: Simply Safe Dividends, Federal Reserve Bank of St. Louis

Many dividend investors are clearly worried. On Friday, November 6^th, a strong US payroll report came out. The Fed watches employment figures and inflation to determine its stance on interest rates, and the strong jobs report signaled that a rate hike in December was now almost a certainty. This would be the first rate increase since 2006.

Immediately, many dividend aristocrats and utilities sold off hard. The XLU utility ETF finished the day down more than 3.5% despite the S&P 500 finishing about flat. Clearly the knee-jerk interest rate trade is to sell higher yielding, slower growing companies like utilities in favor of interest rate beneficiaries like banks (the Financials sector was the strongest performer on Friday) and more cyclical growth companies that would benefit the most from an improving economy.

Before diving into utilities in particular, let’s take a step back and look at the S&P 500’s dividend yield relative to its history and the Federal Funds Target Rate.

As seen below, the S&P 500’s dividend yield sits just below 2% today compared to the Federal Funds Target Rate of 0.25%. If we were living in a dividend stock bubble that could be popped by rising interest rates over the next few years, we would expect the market’s dividend yield over the past several years to be extremely low relative to history.