Utilities Are Sending Warning Signs

The chart above is a weekly chart of the entire price history of the PHLX Utility Sector (UTY). (The PHLX part of the name is just an historical reference to the Philadelphia Stock Exchange, which is now part of the Nasdaq.)

I chose this specific ticker over other utility tickers like XLU or VPU because it provides more historical data and therefore a more powerful statistical analysis.

The channel that you see is a regression channel. A regression channel shows how far above or below the mean price is currently trading. For more details about this channel, you can read the statistics note at the end of this post.

Here are some warning signs that this chart is showing:

1. Utilities are outperforming the broader market. See the chart below.

In the above chart, you can see that the utility sector ETF (XLU) just posted a new all-time high this past Friday. Utilities typically outperform the broader market in the late phase of the business cycle right before (and during) a recession. See below.

Credit: Fidelity Investments

In the main chart above (reposted below) we see that in 2022 price hit the 2nd standard deviation above the mean for the first time since 2007. Price is currently continuing to move higher and it is very possible that it can overthrow the 2nd standard deviation again. This is sending a warning sign that investors are shifting money into utilities because they believe that we are in the end stage of the economic cycle.

2. Utilities are ripping higher at the same time that tech is ripping higher. This is another warning sign. See below chart.

This is somewhat of a nuanced point: Although tech and utilities are not necessarily negatively correlated and can both rise at the same time, they rarely both outperform the broader market (S&P 500) at the same time as they are doing now.

To get to the bottom of what's going on, we should analyze a ratio chart between the two assets. See the chart below.

This chart suggests that tech (QQQ) is rallying because it is testing resistance levels. Tech's performance relative to utilities has fallen below the monthly exponential moving averages (known as the EMA ribbon). It has likely become trapped below the EMA ribbon as it did in 2000. We can be fairly safe in making this conclusion because of the Ichimoku Cloud is forming an ominous coverage (resistance) on the weekly ratio chart similar to 2000 {for this I used the Nasdaq (IXIC) and the PHLX Utility Sector (UTY) for the comparison only because they have enough historical data to form the Ichimoku Cloud for 2000}.

This is a warning sign that tech's rally is merely a bear market rally (or a rally in which resistance levels are retested but price fails to break through).

3. When I analyze utilities relative to the S&P 500 on the yearly chart two additional warning signs appear. See chart below.

First, the yearly stochastic RSI shows that we approaching full oscillation down. The K line has reached oversold territory and has already begun to move up toward the D line. This could mean that utilities are gearing up to outperform the broader market for years to come. Of note, since this a relative chart, it does not necessarily mean that the price in utilities will increase over the period of outperformance, it may merely decline by less than the S&P 500 if both are falling.

Second, the yearly candlesticks fully retraced to the low seen in 1999, right before the Dotcom Bubble burst. Although the SPX can squeeze out one last period of outperformance (one last bull run), the chart is sending a warning sign that this period of outperformance may be coming to an end. Further, the fact these two factors are coming together right as utility prices reach their 2nd standard deviation above the mean, in my opinion, presents a warning of what's to come for the broader market. So much confirmation is quite ominous.

4. Although, utilities are sending a signal that they may potentially outperform the broader market for years to come. When you observe the actual charts of utility components (companies that comprise the utility index), some of the charts are also extremely overbought on the highest timeframes and vulnerable to collapse, or at best stagnation.

Take for example the utility company Next Era Energy (NEE), shown below.

The regression channel in the chart above shows that, during the era of quantitative easing, NEE's price soared over the years to the highest levels that price can typically achieve from a probabilistic standpoint.

If some utility companies are so over-extended to the upside and are vulnerable to collapse or stagnation, then even utilities may fail to serve as a safe haven if the stock market collapses. This is reflective that in the face of quantitative tightening all risk assets are vulnerable to major declines.

My thoughts on how to trade this (not a recommendation): Personally, I'm ambivalent about entering a long position in utilities. Although they may outperform the broader market, since the price is already near the 2nd standard deviation above the mean, and at least some utility components are way overextended, utilities do not present an ideal risk-to-reward trade set up. Nonetheless, if I do end up taking a position in utilities, I will definitely use a trailing stop loss on my position. I see a better option in U.S. treasuries (e.g. TLT). Treasury rates typically go down, and therefore prices go up, during recessions. From a price regression perspective, treasuries are trading at historical lows, and therefore the upside potential is much better. I plan to accumulate treasuries when they reach their terminal rate again or after the weekly chart consolidates, whichever comes first.

With that said, not even trading treasuries is risk-free in this unprecedented time of quantitative tightening and persistently high inflation. If inflation persists, the yields on the 10-year U.S. treasuries may need to rise dramatically higher to definitively squash it. The yearly stochastic RSI for treasuries is providing a tailwind for higher yields over the years. This in turn could bring down the price of treasuries, thereby making not even treasuries fully safe in this new supercycle characterized by persistent inflation and slowing real GDP growth (i.e. stagflation).

Counterintuitively, it's a great time to be a trader as profit will likely only be made by those who constantly shift money into outperforming assets dynamically using charts and technical analysis.



Statistics note: The upper and lower channel lines are 2 standard deviations above and below the mean, respectively. A total of 1,821 data points (total amount of weekly candles) formed this channel. The Pearson score is .95676. This regression line is log-based. Although the data may not be normally distributed, I have found that these regression channels are nonetheless helpful in determining what's more likely than not. The channel lines are not drawn by me, they are automatically generated by the indicator based on the data points, so there is no bias in how they are drawn. I simply apply log-linear regression to the entire price history. This channel is different than a price channel in that the lines are not exact points of resistance or support. Price can easily overthrow or underthrow the channel lines and yet the channel is still completely valid. The channel merely represents probability which helps me base my trades. The channel is not static and changes dynamically with price action, though it becomes more and more static with the introduction of more and more data, which is why I only use regression channels on assets with a lot of data points. Finally, I am not a statistician and do not intend to hold myself out as an expert on statistical analysis.

Additional note: Some of my prior posts back in May and June called for bullishness in tech stocks. Those posts were for the intermediate term (months). Although I saw bullishness for tech in the intermediate term then, in the long term the picture is quite bearish.

Comment:

At the market peak in mid-August, I posted this chart to show that utilities and tech were both strangely outperforming the market, and that tech was likely testing resistance.

Comment:

Look at how much each has retraced since then:

Comment:

For now, and at least until the Fed pivots, tech remains below resistance.