Market Factors: Buy utilities and let others stress about markets

In this edition of Market Factors, a Wall Street strategist suggests buying defensive stocks and forgetting about chasing growth stories. A prominent sentiment indicator brings bad news and a physicist makes a remarkable discovery about dense crowds of people.

Equities

Why it’s time to stop chasing the market

Prominent Wall Street strategist Richard Bernstein thinks equity investors should more or less throw in the towel on risk assets, buy utilities and collect dividends and stable earnings.

In a recent report called A bird in the hand, Mr. Bernstein writes that “Investors’ guidelines regarding the basics of building wealth seem distorted by the current speculative period.” In his mind, investors have lost the plot – scrambling to chase the riskiest sector returns while forgetting the time-honoured route to wealth.

Mr. Bernstein notes that the returns of the stodgy U.S. utilities sector is neck and neck with the tech-heavy Nasdaq Composite since 1971. Investors in utilities, to state the obvious, don’t have to endure anything close to the volatility experienced by Nasdaq investors.

The logic transfers to the domestic market in remarkable fashion – returns for utilities and the broader S&P/TSX Composite Index are virtually the same. Since 1990, as far back as my data goes, the average annual return including dividends for the S&P/TSX Composite is 7.98 per cent. For utilities it’s 7.69 per cent annually.

Domestic investors in utilities would likely have slept a lot better than speculative investors over the past 35 years. They’d be mostly unaffected by the wild swings in the benchmark caused by Bre-X Minerals Ltd. as well as Nortel Networks and the rest of the late 1990s technology favourites.

Utilities investors generated the same returns for the period, making the risk-adjusted returns better than the overall benchmark by orders of magnitude.

It’s not difficult to understand Mr. Bernstein’s timing in writing his piece. U.S. valuations are very extended while investors are pushing the market higher despite risks presented by arbitrary tariff policy, a potential threat to Federal Reserve independence and military conflicts in the Middle East. Risk tolerance might be higher than it should be, in other words.

There is one important caveat here and that’s interest rates. From September 1990 to 2020, the Government of Canada ten-year bond yield fell from 11.2 per cent to 0.5 per cent, and has since retraced some ground to 3.4 per cent. Every move lower made the dividend yield on utilities stocks more attractive. The trend now is likely flat to higher so the tailwind from steadily declining rates is no longer in effect.

Even with this in mind it is tempting to move assets to utilities and worry less about the course of broader equity markets.

Sentiment

Investor euphoria a bad sign

Citi’s Levkovich index, named after the late strategist Tobias Levkovich, has entered euphoria territory, signaling a high probability of a market pullback.

The Levkovich index comprehensively measures investor sentiment using NYSE short interest, GDP growth, profit expectations, inflation, bond spreads, two-year Treasury yields and the New York Federal Reserve recession probability index

The Levkovich index is contrarian – at extremes the equity market is likely do the opposite of investors’ expectation. The median forward 12-month S&P 500 performance when the index is in the euphoria range, for instance, is -9.7 per cent. The probability that equity returns will be positive in the 12-months following a euphoria reading is a meagre 29 per cent.

Diversions

The predictable madness of crowds

A new study published in Nature showed how fluid dynamics can be applied to predict the oscillations of movements in densely packed crowds. The crowds must be really packed in tight for it to work – four people or more per square meter. The insane, chanting Spaniards at the San Fermin Festival in Pamplona were used for the study.

Previously, attempts to model the movement of large crowds extrapolated the activity in small crowds. Didn’t work. The successful study was done by physicists who treated people in crowds as more mindless, like water molecules, instead of accounting for “active-matter hydrodynamics” or individual choices or forces.

Videos of the crowds in Pamplona were found to feature “asymmetric orbital oscillations” at predictable intervals. Speaking of videos, Nature produced an excellent one on the topic here.

This study is not entirely a diversion for investors. Benoit Madelbrot’s study of cotton pricing is only one of many examples of academics continually attempting to render the complexity of asset prices, which seem on the surface to be as random as the movements of large crowds, into predictable formulas.

The essentials

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Globe Investor highlights

David Berman explains why Deere has been a strong, off-the-radar, recent outperformer

David Rosenberg says he’s profoundly disappointed in the U.S. budget bill, and has some portfolio tips on how to position for the ticking demographic time-bomb

Tim Shufelt brings us up to date on the domestic economy – and reports that, rather surprisingly, it’s not broken yet

What’s up next

The net change in employment for June on Friday is the domestic economic data highlight for the coming week. Economists expect a loss of 1,500 jobs. The unemployment rate for June will be released the same day and one tick higher to 7.1 per cent is expected. There are no earnings releases of note on the schedule.

U.S. wholesale inventories for May are out on Wednesday and a drop of 0.3 per cent month over month is forecast. The FOMC minutes will also be released Wednesday where we’ll find out if any governors were leaning towards cutting rates.

The earnings calendar is also light south of the border for the coming week. Conagra Brands Inc. (US$0.587 per share expected) and Delta Air Lines Inc. (US$2.066) on Wednesday are the only two of note.

See our full earnings and economic calendar here