How will utilities perform in 2016 given economic headwinds and volatile energy prices that can impact profitability? How will regulation affect results, with deregulated companies navigating highly competitive environments while regulated companies need legislative approval to raise rates? Finally, what does past price action tell us about future industry prospects?

The utility sector comprises a diverse group of companies that generate power and water for nearly all American homes, while providing natural gas that powers residential, commercial and industrial appliances. The group contains both regulated and non-regulated components, affecting rates charged to customers, with strong regulation often limiting revenue streams.

This is a risk adverse group of companies that can withstand the ups and downs in a typical economic cycle. They also pay hefty dividends, making them perfect vehicles for investors and market timers seeking income over growth. However, they have a love-hate relationship with Wall Street analysts, who often tell their clients to seek return through higher risk instruments until forced to allocate capital in these traditional safe havens.  

Industry Profit Drivers

The industry has bifurcated between winners and losers in recent years because many companies store natural resources that have been battered by the commodity collapse. It’s a double-edged sword because generating power with cheaper fuel produces stronger profits but lower prices reduce working capital, especially if state regulators don’t allow companies to pass through costs to consumers.  

The bottom line depends on a number of factors, including competition, hedges and whether or not they have exploration and production subdivisions directly levered to commodity prices. And, while non-regulated companies produced greater profits two decades ago, the tables have turned due to intense competition, with regulated utilities now showing stronger annual results.  

Coal-fired plants provided 39% of U.S. electricity in 2015 but they’re closing down at a rapid pace, with natural gas replacing the dirtier fuel. It’s estimated another 7% of coal capacity was taken off line by the end of last year, according to Bloomberg New Energy Finance. This transition has increased capital expenditures and dampened profits at affected companies, but they should rebound in coming years, due to the higher efficiency of natural gas electric generation.

The booming solar industry has also impacted traditional operations, with many state laws requiring utilities to buy back energy from residential and commercial consumers who have set up micro-generating stations. They continue to resist these efforts through legislative pressure, seeking to reduce solar incentives or redirect them into the company’s revenue stream.

Historic Price Action

Dow Jones Utility Average (DJUA) contains 15 of the highest capitalized utilities, with a strong emphasis on electric generators. This price-weighted index came to life in 1929 when sector companies were removed from the Dow Jones Industrial Average so the industry could be tracked separately. Membership is changed rarely, with less than 50 components during its 87-year history.

Dow Jones Utility Average 1970 – 2016 (Monthly)

Utility Average Monthly

The index entered a strong uptrend during World War Two, with higher prices continuing into the mid-1960s. It then entered a multiyear downtrend that lasted into 1974, when the Arab oil embargo gave a major lift to the sector, due to higher energy prices. It rallied above the 1960s high in the mid-1980s and continued to post higher highs into February 2001, in the middle of the 2000 to 2002 equity bear market. (For related reading, see: Understanding and Playing the Dow Jones Industrial Average.) 

A steep decline into October 2002 dropped the index to a seven-year low, ahead of a strong recovery that reached a rally high at 555 in January 2008, just before the worldwide economic collapse. It held up relatively well during the crisis, giving up half its 2002 to 2008 gains while maintaining the series of higher lows in place since the 1970s.  

Dow Jones Utility Average 2005 – 2016 (Weekly)

Utility Average Weekly

The index entered a new uptrend in 2009, finally reaching the 2008 high in April 2014. It ground sideways near that level for more than six months, finally breaking out in November 2014 and entering a strong advance that posted an record high at 657 in February 2015. Price action since that time shows a decline that tested new support at the 2008 high, followed by a strong bounce at the same time other equities fell to multiyear lows in January 2016.

2016 Technical Outlook

The Dow Jones Utility Average's relative strength signals a major rotation out of higher beta instruments and into traditional safe havens. This type of transitional activity tends to be long-lasting, with the group set to outperform for the next one to three years. The index has already tested its 2014 breakout successfully, setting up an important test at the February 2015 rally high.

The utility sector shows tight correlation with the U.S. bond market in this flight to safety, as evidenced by an equally strong iShares 20-Year Treasury Bond ETF (TLT). This fund is testing the high posted in early 2015, at the same time that DJUA hit its all-time high. Look for breakouts to new highs in both instruments in the first half of 2016, signaling the start of even greater price appreciation.  

Action Plan

Stick with sector leadership when choosing plays for this strong uptrend. At the same time, avoid companies with E & P divisions because commodity prices will greatly affect their bottom line performance. DJUA components Exelon Corp (EXC) and First Energy Corp (FE) show the weakest technical positioning, offering meager returns while market-leading water plays look like best bets, led by American Water Works Co Inc (AWK).

SPDR Utility Select Sector ETF (XLU) offers the most liquid fund play, trading in a similar pattern to DJUA although it isn’t a tracking instrument. It currently holds 29 components drawn from the S&P 500, with a weighted average market cap of $26.83 billion and a low expense ratio of 0.14%. Vanguard Utilities ETF (VPU) presents an interesting alternative when seeking the broadest sector exposure, with 79 holdings that cover a wider capitalization spectrum. (For more, see: Utilities ETF Crushes the Rest in 2016.)

The Bottom Line

The utilities sector has emerged as a market leader in 2016, with many components hitting multiyear and all-time highs, in a major rotation into defensive sectors and other traditional safe havens. This beneficial trend should continue into 2017, offering investors and market timers many profitable opportunities in an adverse market environment.