Utilities are the New Tech

The big drop in companies’ borrowing costs is the latest sign

The stock market now has a week of trading on the books for 2024. And investors’ focus is where it’s been for the better part of two years: That’s the world’s central banks, particularly the US Federal Reserve.

Until just a few months ago, the big question was how much further the Fed would push up interest rates to quell inflation. Now it’s when the Fed will start cutting rates. And expectations are running hot, with some luminaries forecasting as much as a halving of the Fed Funds rate over the next year or so.

The Fed’s preferred inflation gauge is the so-called “personal consumption expenditures price index,” a measure that does not include food and energy. And on a six-month annualized basis, the index rose by just 1.9 percent in November. That’s less than the central bank’s often-repeated long-term target of 2 percent.

Let’s leave for another day the question of whether anyone can reasonably measure inflation without taking food and energy prices into account. And let’s ignore the fact reduced supply chain disruption and slower economic growth in multiple sectors had a massive impact reducing inflation. In fact, by raising borrowing costs so precipitously, the Fed has crunched investment needed to bridge supply/demand gaps in everything from energy to housing, which likely means more inflation later on.

Barring a deep recession in 2024, the most dramatic expectations for interest rate cuts are likely to be disappointed. But the point is investors have (I think) correctly perceived the central bank is on the verge of declaring victory over inflation. And that means interest rates are likely to head lower over the next year.

The S&P 500 finished the year’s first week of trading lower by -1.5 percent. That decline is mainly due to a loss of value in the Big 7 technology companies currently making up 25.7 percent of the index by weight. Software, Internet, Computer and Semiconductors sectors are 37.8 percent overall.

Big Tech’s share of the S&P 500 is the highest since 2000. That was just as the Nasdaq 100’s historic meltdown was getting underway, along with a massive switch to dividend and “value” stocks.

Like any massive sea change in the markets, more fortunes were lost than made in 2000-02. And the potential for damage this time around is if anything far worse.

That’s because Americans’ money is now heavily passively invested, rather than actively deployed in individual stocks or even managed mutual funds. Instead, lured by the sirens’ call of low fees, many if not most own exclusively products peddled by Wall Street’s marketing giants.

These are basically collections of index exchange trade funds or “ETFs” that are in turn traded by algorithm. And given the weighting of the S&P 500, that means a lot of exposure to the same Big 7 Technology stocks, which trade at historically high prices relative to business value, dividend yield and potential earnings.

These stocks had an historic year in 2023, highlighted best by the Nasdaq 100’s 55 percent total return, its best since 1999. That index’ -3.1 percent first week 2024 loss may be in part due to concerns the Big 7 will face more competition than expected in the race to develop artificial intelligence. But a larger obstacle to sector gains is simply how far these stocks have risen already.

Like the Big Tech sector in 2000, they’re already priced for far more growth than they’re likely to deliver in coming years. And as then, that means any disappointment could be fatal, even for the companies that wind up dominating AI.

As for dividend stocks, many investors appear to be waiting for the central bank to provide clues on when it will start cutting rates. And as a result, they haven’t noticed that actual borrowing costs have already plunged for the companies that rely most heavily on capital spending for growth, utilities being a primary example.

This past week, I conducted in depth balance sheet analysis of the 175 utilities and essential services companies I track in my Conrad’s Utility Investor service. One piece was comparing current borrowing costs with three months ago and at the beginning of 2023.

As my primary gauge, I used “yield to maturity” on companies’ longest-term bonds. If you’re not familiar with bonds, they’re basically loans to companies that investors can buy and sell. A typical corporate bond will pay you a fixed amount of money or “interest” twice a year.

Bond prices rise when interest rates fall, and they lose value when interest rates rise. Yield to maturity or “YTM” is the annual percentage return you’ll receive buying the bond at its current price. The higher the YTM, the more money investors make. Conversely, higher YTMs mean companies are paying more to borrow.

The US Utilities BBB Bond Index measures the YTM on a basket of bonds rated from BBB- and BBB+ that mature (are paid off) in 10 years. As such, it’s a pretty good gauge of what utilities must pay to borrow money when they finance everything from power grid infrastructure to wind, solar and natural gas power plants.

From the beginning of 2022 to early October of last year, the BBB bond Index rose from roughly 2.7 percent to a high of 6.58 percent. That’s a staggering increase in borrowing costs. And it caused many to doubt utilities’ ability to continue investing plans.

In the roughly three months since, however, we’ve seen an abrupt reversal of the trend. The Utility BBB Bond Index has dropped to around 5.25 percent. Results in my Conrad’s Utility Investor coverage universe are more compelling still. The longest-term bonds for nearly half the companies I track have lower YTMs than they did at the beginning of 2023.

In contrast, only four companies’ bonds had higher YTMs than they did in October 2023. And all were because of extraordinary circumstances that potential threaten their survival.

One of them is Hawaiian Electric (NYSE: HE), which in the wake of the tragic Maui wildfire has stopped paying dividends and has had its credit rating cut to junk. I expect the company to ultimately recover, mainly because Hawaii needs it to meet ambitious renewable energy targets.

But the bigger picture is utilities’ borrowing costs have come down sharply, and well before the Fed has made the first move to cut. That augurs deeper declines ahead. And that’s critical, because sector underperformance in 2023 was due to conventional wisdom that higher interest rates would kill utilities’ growth.

Wall Street got it wrong it last year because utilities found other ways to fund projects. And now that interest rates are coming down, that task becomes all the easier. Those who move now to build positions in best in class companies could be headed for their best year since 2000—when the Dow Jones Utility Average soared by more than 50 percent.