Checking Back In on Utilities’ Rally

Have you heard about Utilities stocks lately?

We haven’t, either. Two months ago, when the traditionally defensive sector was outperforming the MSCI World Index and S&P 500, everyone was hot to trot, arguing it was now an offensive play thanks to AI. We disagreed, and recent market movement is weighing in. Let us review.

As the thesis went back then, while Utilities were once stodgy and boring—holding up fine during bear markets but lagging in bull markets, when investors prefer things that grow—they are now a shiny growth play. Why? Artificial intelligence (AI). Supposedly, with all the electricity required to power data centers, Utilities were on the verge of a huge demand boom that would send earnings skyward. Some likened it to the air conditioning boom of the 1960s and 1970s (never mind that Utilities underperformed, cumulatively, in those two decades).

But lately the talk has faded, and we are pretty sure we know why. As Exhibit 1 shows, Utilities is lagging again and has given back most of its earlier leadership.

Exhibit 1: Utilities’ Leadership Was Short-Lived

Source: FactSet, as of 7/18/2024. S&P 500 Index and Utilities sector total returns and MSCI World Index and Utilities sector returns with net dividends, 12/31/2022 – 7/17/2024.

This isn’t a we told you so. It is a lesson and a friendly admonition: Countertrends happen. When a sector has a long leadership run, like Tech and Tech-like stocks did, there will be times when it lags temporarily. Similarly, short leadership bursts may punctuate a sector’s long-running lag, like Utilities did in the late spring. It is no different than the market itself having temporary pullbacks and even corrections (sharp, sentiment-fueled drops of -10% to -20%).

This is why the frantic search for meaning in Utilities’ run was an error. It took what was quite likely a normal, temporary countertrend and sought to give it post-hoc validation, arguing it must have a fundamental cause simply because it happened. Never mind that this was also a time when rate cut hype was resurging (Utilities are interest rate-sensitive) and the broader market was enduring a selloff tied to investors’ nerves over the events in the Middle East, likely leading some investors to seek relative havens. Other defensive categories did well, too. It all looked to us like normal volatility manifesting in various expected ways.

Reading too much into countertrends raises the risk of portfolio errors. Heavily overweighting Utilities in the spring thinking a month’s run meant it was a newly offensive play would have meant buying at the top of a countertrend, potentially rotating out of something that was poised to do well and into something set to lag.

Yes, leadership shifts do happen midcycle. But they tend to act more like a dimmer switch than an on/off switch. And if you are buying into a widely hyped potential shift after a strong run, chances are it is a suboptimal entry point for a simple reason: Those widely discussed positives are already priced in. People have already traded on your thesis and bid prices higher because of it. Real, lasting leadership shifts are sneakier, confusing people with their fits and starts. They also tend to remain unloved for a while as people cling to what was doing well prior and try to rationalize their hopes for a resurgence.

We saw the opposite with Utilities. This won’t be the last time the investing world jumps on a countertrend bandwagon, either, so we hope you will tuck this friendly lesson away for future use.