Is It Time To Flip the Switch on Utilies?

In 2011, utility stocks were the star performer in the S&P 500.

Rising in price by almost +15% for the year, and producing a total return of nearly +20% for the year, the returns from the traditionally "boring" sector of utility stocks trounced the total return of the S&P 500 of +2% for 2011.

This year, however, it has been a completely different story.

Utilities have been the worst performer in the S&P this year.  As the chart above indicates, utility stocks have been a very poor place to invest in 2012. 

So what's going on?

Part of the reason for this year's punk returns, I believe, is the fact that the utility sector was trading at an historically rich valuation at the beginning of this year.

When the S&P started the year on a strong note, the market was quick to sell the overvalued, overowned utility sector in favor of other areas, like technology.

But that doesn't explain why the stocks have continued to struggle in the second half of this year.

Many analysts have pointed to the possible hike in dividend tax rates that may be part of the solution to the pending fiscal cliff discussions in Washington.

My problem with this explanation is that two other sectors that offer high dividends - telecommunications (+15% YTD) and consumer staples (+9% YTD) - have not struggled in the same fashion as the utility sector.

Analyst Brian Chin of Citigroup wrote a report out yesterday discussing the utility sector.

Titled "Why Aren't Utility Stocks Behaving?", Brian lists three reasons he believes that utility stocks have struggled this year:

1. The threat of massive increases in dividend tax rates (again, I don't totally buy this);
2. Demand for power has markedly dropped this year as U.S. corporations have deferred new plant construction;
3. Regulators have begun reducing the allowed returns for regulated utilities in light of today's low interest rates.

If you look at Brian's list, the latter two explanations make more sense to me about what ails the utility sector than the threat of higher tax rates.

Problem is, there doesn't seem to be any near-term changes in these factors in the near future.  Power demand remains sluggish, and the energy markets remain awash in excess capacity.

Trading at 1.5x book, and 1.4x sales, utility stocks are not especially cheap relative to history.  True, relative to bonds utilities stock up nicely, but you could probably say that about nearly every stock that pays a dividend.

Then there's this:  the coal industry bet massively against the re-election of the incumbent. President Obama has proposed significantly tighter emission standards for coal-fired generating plants, and both the providers and users of coal were hopeful that a friendly administration would be put in place.

It doesn't seem likely that any lessening in coal environmental standards will be coming in the next four years.  Utility companies that have older coal-fired plants will either be forced to perform expensive upgrades, or close down the facilities. 

In short, while it is tempting to add to utility stocks here, it seems that the headwinds facing the group might be too much for the foreseeable future.