Recently I posted about what was going on in the Dow Transportation Average here, and how a Market Technician might form his/her analysis, make investment decisions, and advise clients. Today I will briefly examine the Utility Average and explain why it is so important and often goes overlooked, as well as describe why it is projecting a slightly bullish bias in current market conditions.
A Bit of Background
The Dow Jones Utility Average is made up of 15 utility companies that are in the business of electric utilities, gas pipelines, telephone companies, and natural gas. You may see the components of the Utility Average here. Along with the Dow Transportation Average, it is one of the most important averages in existence today, and yet I feel many choose to overlook or disregard it. This is unfortunate for them. The average itself can be somewhat boring by typical investment standards, as it often moves much less than the Industrials and the Transports. Yet it has historically proved to be one of the most reliable barometers of the overall market as well as the Industrial Average itself.
Utility stocks are very sensitive to changes in interest rates because many of these companies require significant amounts of capital to finance their operations, and this means debt relative to equity. Falling interest rates or extended periods of low rates allow these companies to attain favorable financing and this directly contributes to their bottom-line. Not only do utility companies benefit directly from low rates, but the price of their stock benefits indirectly as well. Because utility companies pay out their profits in the form of substantial dividends, they are often compared to bonds. When yields on treasury and other bonds are low, the yields of utility companies relatively become more attractive. The opposite is equally true when interest rates are high and rising; this is negative for utility companies. Perhaps this will give you further additional insight as to why the Fed’s monetary policy is so important to the stock market, even if conditions may not have changed or appear positive.
A Major Technical Principle
One of the major technical principles that CMT’s are taught is that changes in the trend of interest rates usually occurs ahead of reversals in the stock market, and therefore the Utility Average typically will lead the Industrial Average, and therefore the market, at tops and bottoms.
For this reason I consider the Utility Average the “stealth average” since it often quietly goes about its business at the same time the broad indices are alive with activity and preoccupying many investors’ time. Is this what is happening now?
Periods When Utilities Lead Industrials at Tops
Periods When Utilities Lead Industrials at Bottoms
This is not to say that the utilities will always lead, because this is not the case. Oftentimes the peaks and troughs will coincide with the Industrials as has happened recently, and a few times in recent history they have lagged (1970, 1976, 2001). The chart below is the comparison between the Utilities and the Industrials side-by-side over most of the last decade.
You can see from this chart that the Utilities still appear to be headed up while the Industrials have formed an intermediate peak. Also an interesting note about the chart is that volume spiked massively in August when the Utilities briefly but violently sold off. This suggests there is a lot of pent-up demand for Utility companies, a fact confirmed by the quick recovery in Utility prices. The downturn in August doesn’t even register on the monthly chart above.
As I write this the Utilities are only mere fractions away from a 3-year high. A 3-year high! And this is after all of the bearish economic news that has been plaguing the markets of late. While a new multi-year high does not signal a continuation of trend (nor is it a buying signal), it is a bullish indicator that we should pay attention to. The Utilities can diverge from the general market for only so long and the two must ultimately reach trend parity. This gives rise to the possibility that the broad market will follow the Utilities in time.
This concept of analyzing more than one average is what Dow Theory is all about. It should tell you the general market trend for all stocks. As previously stated a new high in one average is not a trend signal until the other averages confirm. When and if the the chart of the Utilities breaks down, one can confidently say the broad market trend is down. However, until that time it may be best to wait for confirmation to be signaled one way or the other, or implement strategies that make use of the strength in utilities.