Are Utility Stocks Running Out of Steam? What You Need to Know

Key Points

• The utilities sector has outperformed the broader market, gaining nearly 18% year-to-date, but may be overbought in the short term.
• The XLU ETF has steadily climbed to new 52-week highs, with its Relative Strength Index indicating overbought conditions.
• Utility stocks have benefited from declining Treasury yields and anticipation of Fed rate cuts, making them attractive to income-seeking investors.

Investors might begin to question whether this surge has gone too far or too fast as the utilities sector continues its impressive climb. With the sector ETF's Utilities Select Sector SPDR NYSE: XLU recent outperformance, some might be wondering if it's now overbought and due for a pullback in the short term. 

So, let's delve into the utility sector's current positioning and analyze its recent outperformance to assess whether there's still room for growth or if now might be the time to take profits and reallocate funds to other market areas, especially with potential interest rate cuts on the horizon.

Utilities Sector: Recent Outperformance

In the wake of the carry trade panic and the subsequent turnaround on August 6th, the utilities sector has emerged as a rare bright spot amid the broader U.S. stock market selloff. Spooked by the volatility in high-flying tech stocks that had led the year's gains, investors sought refuge in utilities. This shift has propelled the sector to be one of the top performers in the S&P 500 since the index's record high on July 16th, with the sector rising nearly 7% over the month, while the broader index, represented by the SPY ETF, climbed about 3%. Year-to-date, utilities have gained almost 18%, outpacing even the tech-focused XLK ETF.

The sector's appeal was amplified by a decline in Treasury yields earlier in the month and the anticipation of interest rate cuts by the Federal Reserve. Often regarded as "bond proxies" due to their stable dividends, utilities have always attracted income-seeking investors. The sector's ETF, for instance, currently offers a 2.71% dividend yield, substantially higher than the SPY's yield of 1.22%. Moreover, utilities benefit from increasing electricity demand to support AI applications, which has bolstered profit growth in the second quarter.

Historically, utilities have performed well during periods surrounding the first Fed rate cut in a cycle. The sector appears positioned for sustained strength with positive ratings, overall bullish sentiment, and recent outperformance. Investors are increasingly recognizing the potential for utilities to capitalize on the growing energy needs driven by AI and other technological advancements.

A Pullback Is Increasingly Likely

Since confirming a higher low in early July within its longer-term uptrend, the XLU ETF has surged sharply, closing at new 52-week highs yesterday. Aside from a brief pullback on August 5th, the ETF has steadily advanced without significant retracement for nearly two consecutive months. From a technical perspective, the ETF's sharp upward trajectory might be considered "vertical," raising concerns about its sustainability. Its Relative Strength Index (RSI), a momentum oscillator that gauges the speed and magnitude of price movements, currently stands at 73.4, indicating that the ETF is in overbought territory. The likelihood of a pullback within its uptrend increases as it continues to climb.

The ETF's top holding, NextEra Energy NYSE: NEE, with a 14.16% weighting, is also trading at 52-week highs within a steady uptrend. Up nearly 33% year-to-date, NEE is outperforming both the market and the sector, but it now sports a P/E ratio of 22 and an RSI approaching 70. The ETF's second and third top holdings, The Southern Company NYSE: SO and Duke Energy NYSE: DUK, are consolidating near 52-week highs with slightly healthier RSI levels. In the short term, momentum tends to favor the bulls, suggesting further upside for the sector. However, as the sector continues to gain momentum in the medium term, a pullback could likely occur within the broader uptrend, as the sector may become slightly overstretched.

Ratings and overall sentiment remain bullish. The XLU ETF currently holds an aggregate rating of Moderate Buy, based on coverage of 99.5% of its holdings. However, due to the sector's recent strong performance, the aggregate price target of $75.79 now suggests a slight downside for the ETF, a gap that could widen further if the ETF continues to rise.