Utilities Aren’t the New Technology

Is it different this time? The Utilities sector—normally stodgy and defensive—is enjoying a rare burst of bull market outperformance in recent weeks. And garnering gobs of attention in the process, with several financial outlets taking notice. One Wall Street Journal piece, which we addressed briefly in our What We’re Reading section Friday, explored an especially bizarre thesis: With electricity use forecasted to jump this year on big demand from artificial intelligence (AI), semiconductor manufacturing and the “nearshoring” of manufacturing in general, Utilities are now a Tech-related offensive category.^[i] We don’t think so, and we will show you why.

For one, Utilities’ run is short. It lagged to start the year (a carryover from 2023), waffled on a relative basis through winter and early spring, and didn’t really take flight until mid-April. So, we are talking about a one-month countertrend.

Saying AI demand is the catalyst ignores a few things. Such as: Utilities are more interest rate-sensitive than other sectors, and rate cut hype is picking up again. Their initial pop in April also coincided with outperformance in defensive bedfellows Consumer Staples and Telecom and a broader market selloff as investors got jittery over the direct attacks between Iran and Israel. So it seems to us that portion of outperformance is indeed more about defense than offense.

Granted, it has carried into May, coinciding with stocks’ return to all-time highs. But if AI is why, then why did Utilities stink up the joint on a relative basis from late 2022 onward? From the bear market’s low on October 12, 2022, Utilities lagged by 28.6 percentage points through yearend 2023.^[ii] AI hype reigned that whole time, and data centers’ purported electricity needs are even older.

Nor is the concept of nearshoring new. Ditto semiconductor foundry builds. Some say electric vehicle (EV) use adds demand and bullishness for Utilities, but EV sales have fallen behind hybrids of late. Another inconvenient fact: People have been talking about EV use stretching electricity demand for years now. It didn’t cause Utilities to outperform then. So why would all these widely known factors suddenly drive returns now? If markets are even remotely efficient, they were pre-priced years ago.

The thesis also has some problems at a fundamental level. To start: Despite all the AI chatter and data centers’ increasing use, data show no material uptick in electricity generation over the last two years.

Exhibit 1 shows this, using the 12-month moving average of US electricity generation to smooth out seasonality. Some might note power generation is running higher over the last few years than in the past, but again: Utilities largely lagged during bull markets over that span. The thesis that higher computing demand made this defensive sector offensive didn’t hold.

That is good reason to question it critically now, in our view. Another: If stock markets are discounting rising demand, then you would expect electricity-related commodities to do the same. But someone forgot to tell coal and natural gas, which are down year to date.

Exhibit 1: No Big Uptick

Source: FactSet, as of 5/17/2024. US electricity net generation, 12-month moving average, February 2006 – February 2024 (latest available data).

The Journal piece perhaps nods to this, stressing Utilities’ forecasts for higher electricity demand from here as the real bullish factor. In doing so, it draws a parallel with the 1960s and 1970s, when the mass-market adoption of air conditioning led to a huge boom in power demand and related expansion in electricity generation capacity.

Friends, there is an inconvenient problem here: Generation doesn’t mean equity outperformance.

As you may have heard, there is a lot of chatter and handwringing about the power grid not being able to handle increased demand from data centers and electric vehicles. If power demand rises anywhere near the degree forecast, it will require a pretty big infrastructure build. Which means Utilities are going to have to invest in new electricity generation and transmission. Those investments amount to high up-front costs that take years to recoup. Expensive!

Utilities also tend to finance this stuff with debt, so undertaking projects now means borrowing at today’s higher rates. It adds up to a cost increase that would offset much, if not all, of the anticipated near-term revenue bump. In other words, disappointing earnings, which stocks tend not to love.

The 1960s and 1970s, which the Journal called a “boom in electricity generation,” show as much.^[iii] Between 1959 and 1973, the US added over 1.5 trillion kilowatt hours in annual electricity generation, a 216% increase.^[iv] So yes, that was an electricity generation boom.

But Utilities stocks did not boom. Exhibit 2 shows their returns relative to the S&P 500 in these two decades. There were two bursts of outperformance: One in the early 1960s and another in the mid-1970s. The latter was a rare spell of leadership during a bull market, but that had more to do with the rebound from the energy crisis than air conditioning euphoria. And more importantly, Utilities lagged most of the time and on a cumulative basis, frequently hampered by high construction costs.

Exhibit 2: Booming Electricity Didn’t Make Utilities Boom

Source: Global Financial Data, Inc., as of 5/17/2024. S&P 500 and Utilities sector total return index levels, monthly, 12/31/1959 – 12/31/1979. Indexed to 1 at 5/17/2024.

Another question: Does computing even have the scale to deliver such a change? The commercial sector consumes about one-third of US electricity. While computing accounts for the largest slice of this, that figure came to 11.4% of commercial consumption in 2022, the most recent US Energy Information Administration data on the subject. It has probably grown since, but how much? That seems like a very small slice to flip a sector to outperformance.

So no, we don’t think Utilities suddenly turned offensive. Countertrends usually end as suddenly as they begin. We suspect this one, too, will reverse before long, making the hype look rather silly. 

HT: Fisher Investments Research Analyst Seth Hersch