Economic Woes Pose Serious Headwinds for Utilities in 2013

by Investing Daily
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In a typical year, utility stocks rally hard in the fourth quarter. In fact, the Dow Jones Utility Average has finished the final three months of the year in the black 36 times since 1969.

Utilities’ fourth-quarter seasonal strength basically reflects big investors’ desire to lock in gains by loading up on more conservative, dividend-paying companies. And the action is typically reversed in the first weeks of the New Year, as money again seeks out more adventurous places.

Only in truly unusual years have utilities failed to rally in the fourth quarter. The crash of 2008 is one such example. Utilities also retreated in both 2001 and 2002, when the sector was suffering its worst bear market in a generation in the wake of Enron’s collapse. And they fell back in the fall of 1993 as well, as the fear of industry deregulation ignited panic.

And 2012 proved to be another exception to the rule of utility fourth-quarter rallies. As per usual, the sector was weaker in the first quarter of the year, following a strong fourth-quarter 2011 rally.

By summer, utilities had strengthened, but by mid-October they were dropping again. The final fourth-quarter damage to the Dow Jones Utility Average (DJUA) was a drop of about 5 percent, or roughly 3.8 percent including dividends paid, though the sector was slightly in the black for the entire year.

Why did utilities fail to rally during the fourth quarter? There are several likely explanations. Worries about the impact of sudden austerity on the US economy–due to the so-called “fiscal cliff”–had gained steam.

Exelon Corp (NYSE: EXC), one of the DJUA’s larger components, dropped 16.4 percent during the quarter on still unresolved concerns about its dividend. And there was considerable uncertainty about what dividend taxes would be in 2013.

The more interesting question for investors now, however, is why utilities are rallying thus far in the New Year–a time when they’ve historically suffered from seasonal weakness.

Calming Fears

Clearly, three trading days do not make a trend. But on Jan. 2, the sector had one of its best opening days ever, closing at a high of nearly 462. That followed a New Year’s Eve rally beginning at just over 443, and the group has tacked on modest gains the past two days as well.

One obvious reason for the rally is the partial resolution of Washington’s budget battle. Utility stocks did not rally immediately when President Bush cut the tax on dividends from a top rate of 39.6 percent to just 15 percent in 2003. Consequently, there was no logical reason for the sector–or any other dividend-paying stock group–to decline if tax rates rose.

There was, however, undeniably some selling of dividend-paying stocks in the year’s waning months due to fears that higher taxes would trigger selling. And utility stocks were caught right in the middle of it.

As it turned out, the tax portion of the budget battle turned out to be a major victory for income investors. The top rate did rise to 20 percent, or 23.8 percent including the new surtax to fund President Obama’s healthcare law. But it only kicks in for income of more than $400,000 for individuals and $450,000 for couples.

All dividend income below that threshold will continue to be taxed at the same rate as under 2012 rules. That’s a sliding scale of between 5 percent and 15 percent, again depending on the relevant tax bracket.

Unlike the 2003 Act, there’s no sunset on this law. Unless and until there’s legislation to change them, these are the tax rates for dividend income. And dividend income is now also at permanent parity with capital gains on tax rates. That’s also a huge win for utilities, which had lobbied hard for dividends to stay on an even playing field as a way to encourage long-term investing.

As is the case for the rest of the stock market, utilities’ New Year rally also reflects relief that the most severe provisions of the Budget Control Act of 2011 will not come to pass. Many economists had forecast a hit to gross domestic product (GDP) of as much as 4 percentage points, had the full package of $600 billion in automatic tax increases and spending cuts actually gone through.

As they proved in 2008, utilities would have fared far better than most businesses, had such sudden austerity tipped the economy into recession. Sector stocks, however, would likely have suffered in the near term due to uncertainty. Mainly, no one really knows how many dollars would be lost in the private sector per dollar of federal spending cuts/tax increases. And until that question was answered, fear would have run rampant.

The passing of what could have been a major blow to the US economy is no doubt a good reason for relief. And the good times could well extend if other economic news continues to improve, both in the US and in Asia, where industrial output is again accelerating.

In addition, utility stocks on the whole are a value in this market. The DJUA is still more than 90 points below the all-time high of about 555 reached back on Jan. 8, 2008. That’s in part because of the sharp drop in Exelon, which has suffered from the decline in wholesale electricity prices. But it’s also in spite of continued robust dividend growth for most of the other stocks in the index.

Beware the Headwinds

That too suggests further upside for utility stocks going forward, in addition to safe and generous dividends. There are, however, headwinds that could put the brakes on this rally and depress returns the rest of the year.

For one thing, the budget compromise passed by Congress and signed by the president last week is still the most contractionary fiscal action by the federal government in decades. Counting the spending cuts that are likely in the coming months as the rest of the budget battle plays out, US austerity measures amount to 1.9 percent of GDP. That’s more than the UK, France or Spain is currently doing, and all three of those countries are currently mired in recession.

Front and center is the end of the so-called “payroll tax holiday,” which means Social Security tax rates will now rise by two percentage points. That’s a tax increase that affects almost every American. And it will arguably have a far greater percentage impact on middle class disposable income than higher income tax rates will have on wealthier Americans.

Even meeting the 0.7 percent annual growth in US electricity demand currently predicted by the US Energy Information Administration will require an enormous capital outlay by power companies in coming years. And that’s not including spending needed to upgrade transmission and distribution systems to meet ever-rising standards for reliability, or for compliance with environmental regulations.

Utilities that can capture a fair return on that spending rate are among the surest investments in the world. Capital spending will flow right to rate base, and from there to earnings, dividends and share prices in coming years.

On the other hand, utilities that are unable to earn a fair return will suffer, just as they did following the capital spending boom in the 1970s. And though most management teams are playing things very conservatively this time around, it is possible we will see dividend cuts and even bankruptcies in extreme cases.

The linchpin is companies’ relationship with regulators. And thus far in this building cycle, most states have been supportive. So has the federal government, which continues to grant generous and stable returns on equity for investment in badly needed transmission infrastructure.

The danger is if austerity worsens Americans’ economic plight enough to fracture the current utility/regulator compact. And to be sure, we’ve already seen some trouble signs, such as the bashing of utilities’ Hurricane Sandy response by certain Northeast politicians.

Many investors consider owning exchange-traded funds (ETF) as the best way to play sectors. And there are certainly options for a sector as widely owned and highly capitalized as utilities. Utility HOLDRs Trust (OTC: UTHYL), for example, is an ETF that tracks the Philadelphia Utility Index–a large-cap index that holds most of the components of the DJUA.

The quality of regulation, however, has historically varied widely between individual states. And while some states can be viewed as reliable supporters of investment, others simply aren’t. Moreover, while a majority of power utilities are at least mostly regulated, some like Exelon are exposed to the vagaries of wholesale power prices.

The bottom line is whatever the popular delusion, utility stocks are definitely not equal as investments. Some are truly destined for greatness going forward and you’ll get them if you buy an ETF. But you’ll also get the sector’s bad and ugly. And if austerity really does dampen the economy in 2013, they definitely won’t fare well.

That makes individual stock selection as critical for the utility sector as for any other. And come what may for federal negotiations on the debt ceiling and government spending this spring, those differences and distinctions will only become more important as the year goes on. For 5 dividend-paying picks that should do well in 2013, see our free report on the Top 5 Dividend-Paying Companies.

This article by Roger Conrad was originally published on Investing Daily under the title: Utilities’ New Year Rally: Will It Last?

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