When Your Investment Turns Bubbly

September 6, 2016 11:16 am
Betsey

Betsey A. Purinton, CFP®

Managing Partner & CIO

Back in the fall of 2000, I suggested to my Mother that she pull back on her portfolio’s stock exposure. My mother was a competent do-it-your-selfer, relying on Value Line and annual company reports to come up with the list of large cap domestic stocks she invested in. At age 85 her portfolio was about 90% in equities. She was a lifelong investor and very proud and passionate about this part of her life.

My mother was also very stubborn and left no room for doubt when she retorted, “Stocks have always been good to me, and I am not changing now.” She didn’t and her portfolio was down over 30% when she sadly passed away in 2002.

I mention this story as a parallel to what I am reading now about utility stocks and the loyalty of many investors to this asset class. Due to extreme pricing, there are warnings coming from respected independent research organizations such as BCA Research and Ned Davis Research and more mainstream media such as Barron’s and the WSJ that the utility sector fundamentals don’t support the high valuations. Problems emerge when utility stock investors love their dividend paying stocks and are loyal to a fault, as was my mother.

It should be noted that all of the above sources cited cushion their warning of an emerging utility bubble with the caveat that “It isn’t over until it is over.” Bloated stock prices don’t usually collapse simply because they are overvalued. They can remain overvalued for a very long time – until some event (perhaps led by the Fed in this case) triggers a pullback and the air is sucked out of the bubble. Bailing now is not the message being sent by the researchers. Rather, they are posting red flags to be aware of and cautioning investors to act accordingly.

My goal is to remind people that they need to have a plan as to what they will do if prices collapse on their favorite investment. Just because a holding or asset class has been good to you, doesn’t necessarily mean that it will continue to treat you well. For those who don’t own utilities, you can replace the word “utilities” with any holding you have that is approaching bubbly territory or which dominates your portfolio, although the particular story of risk will be different for each holding.

First a little background on why utility warnings are appearing.
The love of utilities stems from the fact that the sector yields a 3.3% dividend, which — in the current yield starved environment — is a decent return. In addition, year to date the sector is up 14.64% (XLU). Given that utilities are often viewed as stable, defensive plays, many investors feel they are getting a terrific return without taking a great deal of risk.But these glory days for utilities may be ending.

To begin with, prices paid for utility earnings are over two standard deviations above normal. Translated: 95% of the time in a normal distribution curve prices fall within 2 standard deviations of the mean. This means we are looking at prices that occur less than 5% of the time. There is a significant risk that prices will fall back down to earth, as many stocks over time revert to their mean.

Secondly, utilities benefit the most when interest rates are low because they are heavy borrowers. When interest rates start to rise, borrowing costs for utilities increase and as a result profits often fall. Lower profits mean lower stock prices. In addition, as interest rates rise bonds become more attractive, siphoning off some of the utility stock fund investors.

Thirdly, there is too much capacity (the ability to produce electricity exceeds the demand for electricity) and the fundamental equation of supply and demand is moving in the wrong direction. Corporations are becoming more energy efficient and alternative energy sources are becoming more popular. That could mean an even greater drop in demand that could force utility companies to lower their prices and profits.

So what to do?
Assuming you are not in a managed portfolio (where someone is watching your investments), then you should ask yourself the following questions:

How will I emotionally react if the price of “utilities” (or another treasured holding) takes a terrible tumble, and more importantly, when will I react? In other words, at what point does your feeling of being a winner turn into your fear of being a loser? No one wants to be the investor who bailed on stocks either at the beginning of 1997 or at the end of 2002. In the first case that investor missed out on around 78% in returns before the tech bubble burst. In the latter case, the investor locked in losses of around 46% (using the S&P 500) right before the recovery began. Setting targets (gains and losses) where you could be comfortable selling can help to take the emotion out of your decisions. Then make yourself follow those limits.

Am I really able to stick to my guns and hold utilities because I want to be invested in this holding no matter what?
During the Great Depression, my grandmother (yes, I come from a long line of female investors) held dividend stocks because she felt the dividends were reliable, even if the stock prices were not. Since she didn’t need the principal of her investments nearly as much as she needed the dividends, she was able to ride out the turmoil without becoming too battle scarred. In her case, she was able to define a longer term need that could override any temptation to sell based on an emotional reaction to market volatility.

Do I have time to wait for the recovery? Perhaps my mother felt she would live many more years, with plenty of time to benefit from the tech bubble recovery. I will never know. But I continue to make that suggestion, “Don’t be afraid to take some profits, if you feel you might need the money for living expenses or if you want to hedge the chance that you won’t have time to wait.” If utility prices continue to rise, the remaining portion of your holdings will benefit. If you happen to have sold at the top, you will be thankful of the move you made.

Will changes to the economic environment and/or the financial outlook for utilities cause a major shift in the attractiveness of this sector? Potentially yes. Over the intermediate term the outlook for utilities is not favorable due to rising interest rates, over supply of plants and facilities and falling demand. However, for as long at the Federal Reserve remains on hold, the outlook for the sector remains relatively positive. Any turning point on stock prices depends on when investors decide the inflection point is near.

Just as investors were concerned about the prices of technology stocks in 1999, warnings may be early for utility and other dividend paying sectors right now. My advice: have a plan in place for when your darlings rollover. The red flags are there for a purpose. Don’t ignore them.

Betsey A. Purinton, CFP® is Managing Partner  and Chief Investment Officer at StrategicPoint Investment Advisors in Providence and East Greenwich. You can e-mail her at bpurinton@strategicpoint.com.

The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.