NEW YORK (TheStreet) -- Utility stocks have sharply outperformed the broader market over the past month, but don't be fooled by the recent advance: Investors need to be cautious about the group and realize that its drivers of late are not likely to persist.
While utilities absolutely have a place in a diversified investor's portfolio, given their strong and steady dividend programs, the recent share advance has little to do with the group's fundamentals and future growth prospects. Instead, the move has come on theories about when the Federal Reserve will issue its first interest rate hike in about 10 years. The latest economic data has been weak, suggesting an increase is unlikely to come in September, as many market watchers had previously expected. If that ends up being the case, that means a few more months of a zero-rate market, the kind of environment where utilities thrive.
The question for investors is, given the rally in utility shares, will a few more months translate to appreciable share gains from here? Don't count on it. The S&P Utility sector (as tracked by the Utilities Select Sector SPDR ETF(XLU) - Get Report and others) is up about 6.8% over the past 12 months, but the vast majority of those gains have come alongside changes to Fed expectations; six points of that has come in the past 30 days alone. (To compare, the S&P 500 is up about 2% over the past month.) With that move, which has diminished the group's valuation play, jumping in here presents more risk than opportunity.
The recent rise has also created expectations the sector is having trouble meeting. Thus far this earnings season, only 56% of utility stocks have topped earnings expectations, according to FactSet, far below the 73% beat rate of the overall market. On the revenue side, only 24% have beaten, less than half the 52% rate of the overall market. Furthermore, utilities are posting the biggest downside surprises relative to revenue expectations of any S&P sector.
Utilities thrive in low-rate environments as their high dividend yields make them an attractive alternative to bonds. Currently, the sector is yielding 3.86%, above the 2.225% yield of the benchmark 10-year Treasury note. (The S&P 500 is yielding 2.08%.) While this perk won't vanish when rates begin to rise, if investors reposition out of the sector, the resultant drop may be enough to offset the benefits of the higher dividend.
Investors should have some exposure to the sector, though they need to be cautious about adding to positions. Currently, about 20% of our equity assets are in utilities, and some are components of our Dividend Busters Program, which is comprised of 15 high-quality dividend-paying stocks. However, there's another sector that offers strong yields, and it also comes with more attractive valuations: energy shares.
While energy has been under pressure of late, dropping largely on concerns that slowing growth in China will muffle demand, that selloff has the group trading at an attractive discount. Yes, energy sector profits are down 57% this quarter, the worst growth of any sector, but once growth and demand pick back up -- and they will, if investors can be patient -- the group is well positioned to advance. International oil plays like Total S.A.(TOT) - Get Report, BP(BP) - Get Report and Royal Dutch (RDS.A) offer a much better play at current levels than anything in the utility space.
This article is commentary by an independent contributor. At the time of publication, the author's equities portfolio was about 20% utilities.