You Won’t Like What Utility Stocks Say About Interest Rates

What's with utility stocks and why should investors care?

Watching the price action of the utility stocks is very important to investors, as the utility stocks are leading indicators of interest rates. By watching the price action of these stocks, we can relate their price direction to where we expect interest rates to go.

Interest rates are of fundamental importance to all kinds of investors, from active stock market investors to retirees looking for income, to businesses that need to borrow money for their businesses, to even currency traders. The direction of interest rates is of utmost importance to investment decision-making.

After peaking in December of 2007 at 210, the Dow Jones Utilities Index sits at only 150 today—still down 29% from its high. While other stock sectors, like retail, are close to breaking above their 2007 price highs, the utility stocks are struggling. Why, and what does this mean for interest rates?

Before we get to the "why" we need to look at where the utility stocks have been. As a big believer in stocks being a leading indicator, the run-up in the price of utility stocks in December of 2007 foresaw the record-low interest rates we would experience in 2008 and 2009.

While the official Federal Funds Rate remains between 0.25% and zero, the utility stocks are not rising because, in my opinion, they now foresee interest rates rising in the near future. As you know, if interest rates rise, the price of utility stocks declines, as their yields become less attractive when interest rates rise. Stocks in general decline as interest rates rise.

If we look at all the pieces of the puzzle—record-high national debt that the U.S. government needs to continue financing via the issuance of bonds; pressure on the U.S. dollar to decline in the face of rising national debt; pressure on domestic inflation to rise as the Fed's too-easy money policy goes on for too long—they all point to higher interest rates ahead. The price action of the utility stocks this year confirms my concern over higher interest rates in 2011.

Michael's Personal Notes:

A two-page spread appeared this weekend in Toronto's Globe and Mail with the heading, "The Case Against Gold." The article points out that demand for jewelry is on the decline and the supply of gold is rising, and compares the "bubble" in gold bullion to the previous bubbles in high-tech stocks and real estate.

Everyone's entitled to their opinion. But I disagree with what the writer of, "The Case Against Gold," had to say for several important reasons:

If we take inflation into account, the price of gold has yet to break to a new price high. Demand for jewelry is obviously falling, as consumers cannot keep up with the rising price of the gold used in jewelry. Bubbles, just like the high-tech bubble of 1997 to 1999 or the U.S. real estate bubble of 2003-2006, can go much higher than common sense could ever expect.

Finally, gold has always been a safety net and an inflation hedge. Investors and consumers do not know the long-term effects that rising record U.S. debt will have on the greenback. Similarly, we do not know the long-term effects that the unprecedented easy money policies of the Fed will have on inflation. These are the fears that will drive gold.

Where the Market Stands; Where it is Headed:

The Dow Jones Industrial Average opens this morning 41 points below its 52-week trading high. I believe the chances favor a breakout by the market to a new high, as opposed to downside action. Both the S&P 500 and the NASDAQ broke to new 52-week highs last week…I don't see the Dow Jones far behind in terms of a new high. If I look back at recent trends, the Dow Jones has lagged behind both the S&P 500 and the NASDAQ in terms of market direction.

Total return (growth and dividends) this year for the stock market will be in excess of 10%—a better performance than bonds by far, but one only half the return investors would have gotten by being invested in gold bullion.

The bear market rally in stocks that started in March of 2009 continues.

What He Said:

"Consumer confidence does not change overnight. In the U.S., 70% of GDP is based on consumer spending. And, in my life, all the recessions I have seen or studied have only come to an end when consumers started spending. With consumer sentiment getting worse, and with the U.S. personal savings rate near record lows, it may take two or three years for consumers to start spending again." Michael Lombardi in PROFIT CONFIDENTIAL, February 25, 2008. By the end of 2008, the rest of the world was realizing that the recession would be much longer and deeper than most had guessed.