Pounding the Table on a Deep Value Sector

By TradeSmith Research Team

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The scariest words in finance right now are “interest rates.”

Surging yields are causing turmoil in markets, and the utilities sector is the poster child for the carnage.

A couple of weeks ago, I discussed the extreme forced selling occurring in the sector. And the risk-off narrative has only increased ever since.

Today we’ll dive into the overall landscape for utilities stocks. Then we’ll see if the evidence still supports the bullish case.

Elephant in the Room

Let’s begin with the obvious elephant in the room: interest rates. They are ripping higher.

The U.S. 10-year Treasury yield has reached 4.8%, a level not seen since 2007:

Source: FactSet

When rates rip, stocks dip. The S&P 500 has now pulled back 8% from its late July peak.

But that’s peanuts compared to rate-sensitive utilities sector.

Notice in the chart below how dramatic the underperformance has been for the Utility Select Sector SPDR ETF (XLU) vs. the S&P 500.

While the market is up 13% year-to-date, this broad gauge for utilities stocks is down a whopping 19%, creating a 32% underperformance:

Source: FactSet

This is quite a bit of added destruction since my last take when utes trailed the market by 25%.

But, looking at 2023 only offers a glimpse of the sector’s relationship to the overall market.

Going back decades, today’s action is making history. The XLU ETF is now trading at its largest relative underperformance to the S&P 500 since 2003.

The lower the blue line falls, the greater the fall in XLU vs. the market.

Source: FactSet

This freefall in price is creating panic selling. One of my favorite indicators confirms this is EXACTLY what’s happening.

The chart plots the daily buy and sell counts for the utilities sector. Red lines are sell signals, and green lines are buys. The blue line is the price of XLU.

On Monday, this chart nearly broke a record as 44 utilities stocks were sold in a single day. The only time we saw more was during the pandemic.

Looking above, you’ll notice a total of 7 recent periods (including Monday) when selling was off the charts. September’s big selloff, with 24 utilities stocks sold in a day, looks more like a game of patty-cake compared with the 44 names dumped earlier this week.

Which then begs the million-dollar question: Should we stay with the bullish thesis or abandon ship?

It’s Time to Be Greedy

By now you know that I’m a disciple of data. Reviewing history will help us draw a conclusion.

As Warren Buffett famously said, we aim “to be fearful when others are greedy and to be greedy only when others are fearful.”

History says that now is the time to be extra greedy. Here’s a reminder of what to expect after monster selling occurs in utilities stocks.

First of all, look at points 1, 2, 3, and 4 in the chart above. Each time utilities got smacked, they ripped higher not long after.

Today’s the exception. Since we started seeing major sell signals about two months ago, utilities have kept sliding.

But let’s go back further into history.

The table below shows that since 2013, after more than 20 utilities stocks are sold in a day, XLU soars an average of 5.3% a month later.

Six months later it’s even better, with an 8.7% lift.

Hold for 12 months and it’s a 14% ripper:

With green like that, I can’t turn away from my bullish stance.

Betting with this historical tailwind at your back says the deck is favorably stacked. Those fearful words “interest rates” don’t seem so fearful anymore.

Always focus on the opportunity. Right now, that opportunity is in utilities stocks.

Their valuation relative to the market is dirt cheap — and a seasonal fourth quarter rally will light a fire under this group.

And that’s how TradeSmith’s data-driven process stays one step ahead of the crowd. Data helps us find the trades most investors aren’t even thinking about.