Warning: It's Time to Exit This "Safe" Sector

Income-seeking investors, be warned…

Dividend-paying utility stocks have had a heck of a run. Money has been flowing into this sector for over two years – utilities have even outperformed the S&P 500. Record-low interest rates have made these safe, high-yield stocks a great alternative for investors chasing income… After all, Treasurys and money market funds are earning negative returns (after inflation).

But conditions are falling into place for a major trend reversal. In fact, we could see utility stocks significantly underperform the S&P 500 Index in the years ahead. Let me explain…

Utility companies provide power, water, and natural gas. They have important assets, but grow really slowly. That’s because local governments limit their ability to raise prices. In exchange for the high regulations, however, utilities get to dominate their markets. They generate huge cash flow, which is typically used to pay big dividends to their investors.

That safe, stable income has helped the big utility fund (XLU) outperform the S&P 500 by five percentage points (including dividends) in the last two years. That doesn’t sound like a wide margin. But it’s significant when comparing safe-income-oriented asset classes.

                                                        

However, I believe this trend is about to reverse.

President Obama based his reelection campaign on raising taxes on the wealthy. He’s also been adamant about letting the Bush-era tax cuts expire on January 1, 2013. One of those cuts includes the rate charged on dividends.

Today, the tax rate on dividend income is 15%. If this expires, the tax rate on dividends would jump to 39.6%. That would significantly reduce the rate of return on dividend-paying stocks like utilities.

Democrats and Republicans may come to terms on this issue. They may agree to raise taxes on dividends only slightly. But utility stocks are still a “sell” here…

My colleague Dr. David Eifrig, editor of Retirement Millionaire, recently told DailyWealth readers that the tax hike won’t affect most S&P 500 companies. I agree that the stocks in this index should perform well overall going forward. But we’re talking about a potential 25% tax hike on dividends. We’ve never seen anything like this before. And utility stocks are particularly vulnerable because investors own them solely for yield.

These companies are also incredibly overvalued. According to Russ Koesterich, global chief strategist for investment giant BlackRock, utilities historically trade at a 25% discount to the S&P 500. Today, they are trading at a 15% premium. That’s based on the S&P 500 trading at 14 times earnings and the utility sector trading at 16 times earnings.

If you are a value investor, or student of investment legend Jeremy Grantham, you’ll recall that all asset classes eventually revert to their fair value in time. In other words, we could see a massive pullback in utility stocks if they go back to their long-run average – trading at a discount to the S&P 500.

In fact, we are already seeing the early stages of this trend. Even before Wednesday’s huge pullback, the utility sector (XLU) crashed through its 200-day moving average (DMA). This is a widely used technical indicator to gauge the general long-term trend of an asset. Since XLU broke below its 200-DMA, it means shares will likely continue heading lower.

To be clear, I am not saying to sell all dividend stocks. I recently gave you two examples (here and here) of dividend payers with huge growth potential. As I said earlier, utility stocks grow slowly. Most investors buy these stocks solely because of their yield.

If you don’t own shares of utility stocks, I don’t recommend buying on this pullback. If you do own shares, I recommend lightening up your positions heading into January 1. If the tax break on dividends expires, we could see an even bigger pullback in this overvalued sector.

Source: