It is if it is invested entirely in a Utility Sector ETF. This year’s stock market action can be summarized very quickly: The better the yield, the better the sector performance. We looked at the year-to-date performance and dividend yield for each of the ten S&P 500 industry sectors. The data is in the table below. We then did a scatter plot of the YTD sector performance on the x-axis versus the current sector yield on the y-axis. It turns out there is a very high positive correlation between the sector yield and this year’s sector performance. That’s not a huge surprise – investors have been starved for yield as interest rates have plummeted. The surprise was how strong the correlation was. If you had simply bought the highest yielding stocks in the S&P 500 at the beginning of the year, you’d have outperformed the overall index quite handily.
There is only one glaring exception to the otherwise strong correlation between yield and performance: the Financial sector. Why has the Financial sector (largely comprised of banks) performed relatively badly this year even though the sector is yielding an above-average 2.3%? Because bank profitability has suffered from the relentless recent drop in interest rates. Banks need interest rates to rise in order to earn more spread income on their loans (and therefore increase their earnings). As the Fed has consistently pushed back its planned interest-rate increases, the bank stocks have underperformed.
Another observation: the sectors with the highest yields are also those with the smallest weightings in the S&P 500. Therefore, if you owned equal weights of each sector rather than the actual market-cap weights, you would have done significantly better than the market. Again, the big outlier here is the Financial sector, which comprises 16% of the S&P 500 market capitalization but has produced a negative return so far this year.
Source: Standard & Poors
Source: Standard & Poors
The dramatic rotation into high-yielding sectors this year suggests that stock investors are operating under the assumption that any meaningful increases in interest rates are well off in the future. But if the consensus is wrong (which it very often is) and rates rise quicker than expected, investors who are now pouring into bond-like sectors (think Utilities and Telecom) could suffer sizable losses as money exits those sectors as fast as it has come in. In other words, there is significant interest-rate risk associated with owning sectors that trade almost exclusively based on their dividends (rather than the very modest growth they might offer). The interest-rate risk might not be as high as owning long-term bonds, for instance, but there is little doubt that sectors like Utilities and Telecom will suffer losses if interest rates rise significantly.
On the other hand, a rising interest-rate environment should provide long-needed relief for investors in the Financial sector. Higher rates would be a boon for banks that are sitting on piles of cash just waiting to be deployed into higher-yielding assets. As the cash is reinvested, bank profitability should improve dramatically. The improved profitability would benefit bank investors through better earnings growth, higher trading multiples, and increases in dividends. This is why we wrote earlier in our April 8 Market Commentary that the Financial sector could serve as a good hedge against rising interest rates. It would appear from the data above that this remains the case.