The Fed Induced Bubble in Utilities Continues to Grow

Posted: Jul 07, 2016 12:01 AM
The Fed Induced Bubble in Utilities Continues to Grow

Income investors have been forced out of usual safe havens like CD’s and U.S. Treasuries because of next-to-nothing interest rates.

While it is true that the market sets interest rates, the Fed continues to maintain an almost Zero Interest Rate Policy (ZIRP) for the eighth straight year.

Every time the bond gurus call for higher rates, they seem to go lower instead.

This trend in lower rates is also a global phenomenon. Japan has now entered into uncharted territory of negative rates.

Will interest rates in the U.S. ever go negative? Ms. Yellen says that while the FED has the legal authority to take them into the minus column, even she thinks that rates are more likely to go higher from here.

Germany has also recently joined the still exclusive negative rate club.

So has Switzerland…

This continued lower rate environment continues to force investors into other income-producing vehicles like utilities, real estate investment trusts (REIT’s), and dividend paying stocks. In fact, the demand for these aforementioned income producers is now growing to a feverish pitch.

As the voracious appetite for yield continues to grow, so do valuations! Income investors continue to gleefully watch their utilities, REIT’s, and dividend paying stocks go higher and higher. At the same time the underlying valuations are doing the same thing.

Of the three asset classes mentioned above, the valuation bubble is becoming most pronounced in the utility sector. Widows and orphans might want to stay alert here, I am not so sure that valuation is measured by those pre-programmed robo-adivsors.

Value can be measured in many different ways. Some like to use price-to-earnings ratios; some like price-to cash flow; others like price to book value, or even price to sales. But, no matter what flavor that you like, these dividend producers are getting expensive.

While I love to see my utility ETF (IDU) hitting new highs, I also get worried about investors becoming almost euphoric as prices go higher and higher and higher! Euphoria in the market never seems to end well.

Look at the action in the utilities this past week! How can you not take a pause and analyze current valuations.

Let’s take a deep breath from our excitement over NEW ALL TIME HIGHS and take a look at a valuation sampling of several utility stocks.

My money management firm is headquartered in San Diego, so let’s begin with my local Utility, Sempra Energy (SRE):

The five-year chart of the price action looks fabulous. Plenty of Euphoria here, except when I get my monthly bill. The stock broke out to new, all-time highs this past week. Maybe buying the stock would make paying those monthly energy bills that come in the mail more palatable.

If your favorite flavor of value is price to earnings, you are going to find that there are more and more marshmallows showing up in the PE ratio of Sempra by the day. The average PE ratio of Sempra over the last ten years has been somewhere in the range of 15-18. The current PE ratio is now 23X after this week’s big move.

That is a lot of fluff in those marshmallows, I hope that investors don’t eventually get toasted.

During the last ten years, the average price to book value ratio has been about 1.5-1.7, the current price to book ratio is now 2.4. Widows beware.

Price to cash flow also looks stretched at its current level. While this ratio has averaged somewhere in the 6-7 times range over the last decade, it is currently stretched out all the way to 10.6X. The stock is going to have to move out a few more notches on its belt.

What is the attraction of this utility stock that has been growing its earnings of just 4% per year over the last five years?

Why it must be the dividend yield of 2.7%! It sure looks better to income investors than CD’s, U.S. Treasuries, or Japanese bonds. The yield continues to plummet, however.

Before we move on to our next patient, let’s take the temperature of Sempra’s price to sales ratio.

It is currently running a temperature. The ten-year average has been about 1.4, and it is currently running at a feverish 2.4X.

By any valuation measure, Sempra Energy is an expensive stock.

Let’s go north a bit and see if we can get a better deal in Los Angeles. My dad used to take us boys to L.A. every year to get our new church suits-much better deals up there.

The five-year chart Edison looks like one of the fireworks that I saw on the fourth of July. It too is lighting up sky with new all-time highs.

Unfortunately so are the valuations.

Let’s look at the four common valuation measures for EIX:

Average PE ratio=13x-16x. Current PE ratio=23X.

Average Price to Cash Flow ratio=3X-4X. Current Price to Cash Flow Ratio=5.8X.

Average Price to Book Value Ratio=1.2X-1.6X. Current Price to Book Value Ratio=2.2X.

Average Price to Sales Ratio=1.0X-1.3X. Current Price to Sales Ratio=2.2X.

Edison looks like another ultra-expensive utility stock to me. I may as well stay in San Diego for my suit this year. That dividend yield of 2.7% that everyone seems to be chasing could be more than wiped out by a 10-15% valuation correction in the stock.

Here is the argument that I usually hear from investors, however: “I am still getting my dividend.”

This makes no sense. Investing is about total return. What good is a 2.7% dividend yield when you lose 15% of your principal?

Maybe folks are just paying up for these Southern California utilities because the weather is so nice and Disneyland is nearby.

Let’s go to Detroit instead and examine their electric and natural gas utility, DTE Energy (DTE).

The five-year chart looks just like the other two, new all-time highs!

Darn, so do the valuations.

Average PE ratio=15x-16x. Current PE ratio=19X.

Average Price to Cash Flow ratio=6X-7X. Current Price to Cash Flow Ratio=8.6X

Average Price to Book Value Ratio=1.0X-1.2X. Current Price to Book Value Ratio=1.5X.

Average Price to Sales Ratio=1.8X-2.0X. Current Price to Sales Ratio=2.6X

Sorry Detroit, your utility is just as expensive as our utilities. But, we still have Disneyland.

Before we pronounce a verdict, let’s call one more witness to the stand. Let’s go way back to NASCAR country in Charlotte, North Carolina and check on Duke Energy.

I’ll bet that those Carolina Panther tickets are going to be a little pricier this year after last year’s Superbowl appearance.

How about shares of Duke Energy?

Here we go again. Nothing but blue sky and new highs! While investors may getting a little euphoric, let’s see how the thin that the air is getting up there.

Average ten year PE ratio=13X-15X. Current PE ratio=25.4X.

Average ten year Price/Book ratio=1.1X-1.4X. Current Price/Book ratio=2.0X

Average ten year Price to Cash Flow Ratio=4X-5X. Current Price/Cash Flow Ratio=9.4X

Average ten year Price to Sales ratio=1X-1.2X. Current Price to Sales ratio=1.8X

Once again, another testimony of stretched valuations in the Utility Sector.

I could go on with several others, but for me the verdict is in: GUILTY.

The FED is creating a huge bubble in income producing asset classes, but nowhere is it more pronounced than in the Utility Sector right now.

You might want to keep your eye on SDP (inverse utility ETF). It currently continues to hit new all-time lows, but it may come in useful at some point in the future.