Chasing performance is a tough game to play, as investors usually end up buying in near the end of a run, missing most of the gain, and then selling after prices have begun to retreat. Additionally, loading up on securities simply because they have recently done well can throw a portfolio off balance, leaving investors exposed to more risk than they may realize.

Having said that, it is difficult to ignore the strong recent performance of the telecommunications and utilities sectors. Obviously we are surprised to see them as the top performers so far this year—by quite a margin—as we had, and continue to have, underperform ratings on both sectors. While disappointed that we missed the recent move, we can’t live in the past—we can only learn from it, and attempt to make solid calls in the future.

So why did these two sectors move contrary to our expectations, and what is the current outlook?  There are always a myriad factors affecting stock movement, but a perfect storm formed at the beginning of this year for telecom and utilities. Market concern about a possible U.S. economic slowdown escalated—far more than was justified by the data, in our opinion—sending many investors into traditionally more-defensive areas of the market, including sectors such as telecom and utilities. At the same time, investors flocked into safe-haven U.S. Treasury securities, driving down long-term yields (which move inversely to price). Lower shorter-term Treasury yields also resulted from the markets perceived reduced likelihood of Federal Reserve interest rate hikes this year, reigniting the hunt for yield. And that, in turn, drove investors toward defensive stocks that typically pay higher-than-average dividend yields, which are generally found in the utilities and telecom sectors.

So what now?
We’re sticking with the underperform rating for both the utilities and telecom sectors, for two reasons: We believe the market has been reassessing the above assumptions, and we’ve seen a reversal of sentiment about the U.S. economy. In fact, the utilities and telecom sectors have been among the worst performers over the past month, as stocks have rallied and interest rates have bumped higher. We believe this trend will continue, as the U.S. economy appears to be stabilizing, with durable goods orders rising, manufacturing surveys improving and the labor market remaining tight.

We’re not saying—and the data isn’t showing—that the economy is off to the races. However, it doesn’t appear to be deteriorating, which should diminish the attractions of traditionally defensive sectors. Coinciding with this better outlook has been a modest rise in Treasury rates, reversing some of the hunt-for-yield trade from equities back to fixed income. Finally, on the big-picture front, we’ve seen inflation start to gain some traction, which tends to influence interest rates higher while also raising Fed rate hike expectations, both likely detrimental to the performance of utilities and telecom.

Drilling down a bit into the individual sectors reinforces our belief in our underperform call. With telecom, there are a couple of things to realize off the top. First, it is a very small sector, with only five companies in the S&P 500® Telecommunication Services Index. This means the sector has greater-than-average exposure to individual company factors. Additionally, we believe the traditionally defensive nature of the sector is changing. The fixed-rate, fixed-line telephone business, which once made telecom companies more like utilities, is disappearing. Instead, the explosion in wireless communications and mobile data—cellphones, smartphones, tablets,  video streaming on mobile devices, etc.—has created a much more competitive communications environment. Companies have to fight on price, as well as invest in system enhancements to handle all the new traffic on their networks. As a result, they’ve had to take on more debt, with the average debt-to-asset ratio rising to almost 39% from about 25% four years ago, according to Ned Davis Research. Meanwhile, pricing power in the group is poor: From December 2009 to September 2015, the Consumer Price Index for wireless telephone services fell 13% while the all-items index increased 10%. To us, this doesn’t paint a particularly attractive investment picture.

Within the utilities sector, the correlation of stock prices to bond prices has skyrocketed over the past several years, averaging about 62% since 2010, according to Ned Davis Research. This makes the group vulnerable to even a modest rise in interest rates—remember that bond prices tend to fall as interest rates rise—which we believe is quite possible as inflation measures have started to rise. Additionally, valuations continue to be a concern for us: the current price-to-dividend ratio is nearly 29, well above the average (since 1970) of around 19 (Ned Davis). Finally, we are more than a bit concerned about the regulatory environment. There has been and continues to be a movement to impose costly new environmental standards onto many utility companies, which we believe will pressure margins and profitability in the near term.

We certainly missed the call for the first month of 2016, and are quite disappointed by that. But  we can only look forward, and we believe the above case outlines clearly why we believe the utilities and telecom sectors will underperform the market in the coming months, much as they have over the past month.

Brad Sorensen, CFA, is managing director of market and sector analysis at the Schwab Center for Financial Research.

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