Utilities are traditionally thought of as a defensive sector that attracts capital seeking a safe haven from broader market volatility that also pays a reliable dividend. Conventional market wisdom of market behavior advises us to never say 'this time is different' . Nvidia CEO Jensen Huang has said that we are at the start of a new industrial revolution, referring to the massive hardware and software buildout as we enter the age of artificial intelligence.
This new infrastructure requires a considerable amount of electricity to operate. According to a research report done by Goldman Sachs, a ChapGPT query requires about 10 times as much electricity as a Google search. As we look at the strength in the utilities within this context we might feel justified in saying this time might actually be different.
Before we go down this path, we must acknowledge the traditional intermarket relationship of utilities that tend to trade with an inverse relation to interest rates. If the view that yields have topped, capital will flow out of fixed income markets and into stable dividend payers. Yields likely topped in the fourth quarter of '23 and have trended lower as we're heading into our first rate cut in September.
Overlaid on the U.S. 10-year yield chart is the Utilities Select SPDR ETF (XLU) showing a clear inverse correlation that set the stage for a rally in utilities.
Now it's true that a move lower in yields set the stage for a broader rally in the stock market as shown in the S & P 500 ETF 'SPY' and Utilities ETF 'XLU' overlay below. However, looking at the ratio of XLU / SPY in the panel at the bottom of the chart you'll see the ratio turned up on Feb 2. That means that utilities have actually outperformed the S & P since Feb of this year.
Looking at the main part of the chart you'll see that XLU has not broken to all-time highs set in 2022 as the S & P clearly has. Perhaps there's a catchup play happening here from the 1-2 punch of lower US yields and significant expected power demand from AI going forward. Within the utilities sector the top five strongest stocks based on a technical and fundamental scan I've built are all in the electric utilities industry.
Those names are Pampa Energy (PAM) , Southern Company (SO) , Pinnacle West Capital (PNW ), NextEra Energy (NEE) , and Duke Energy (DUK) . Outside the top five, but still notable is newcomer Talen Energy (TLN) . I would like to focus on Southern Company.
A utility breaking out Southern Company is a power generation company that understands solar, coal, and natural gas production methods, but SO has also navigated the regulatory challenges of nuclear power better than their competitors. The outlook is the energy demands of AI will likely find nuclear as the main supplier with solar as the backup, which SO is well positioned to provide. The company is not cheap trading at 21 times next year expected earnings, but the expected growth rate may well justify the valuation.
Southern company made $3.65 in EPS during 2023 and is expected to grow that 11% to $4.04 in 2024.
In the last earnings report the consensus EPS was $0.93, but far exceeded that by 17% earning $1.09.
Q3 earnings are due on October 31st and consensus EPS is at $1.40. SO broke out through $80.
00 resistance and while above this newly formed support level we see the chart moving towards the $100 level in coming quarters providing a nice risk-reward ratio while paying you a 3.3% yield along the way. Remember, we're not supposed to say this, but utilities might be trading along with the tech stocks led by semiconductors as we move further into the new industrial revolution.
And so this time might actually be different. -Todd Gordon, Founder of Inside Edge Capital, LLC DISCLOSURES: (DISCLOSURES: Gordon owns SO and DUK personally and in his wealth management company Inside Edge Capital. Charts shown are MotiveWave ) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium.
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