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Utilities eked out a small 0.5% gain for 2018 on the heels of a massive Q4 rally as the market turned decidedly defensive ending the year down 6.2%.   Utilities 670bps outperformance came despite a lot of headwinds on the group including higher interest rates (10-yr up 23bps), lack of tax reform benefits, over $15B of equity issuance, and the CA fires impact.  Investors were looking for any place to hide and utilities fit the bill especially given their lack of exposure to tariffs and recession fears.  Utilities came in second among income sectors for the year trailing only Pharma which was up 5.2%.  Interestingly, all other income sectors underperformed the market in 2018 (see Exhibit 1).  We remain cautious on utilities going into 2019 given their heavy dependence on a negative macro call and very high relative valuations (20% adjusted P/E premium vs the historic avg of 3%).  In our view, buying defensive sectors at historically large premiums is not defensive.

Market volatility in October caught many off-guard and the hope was things would settle down post earnings.  Well they got much worse spurred by the disruption of the CA fires.  PCG and EIX ended November down 44% and 20%, respectively, on the heels of the destructive fires.  These were popular value names in the utility space and their sharp stock collapses clearly caused investor pain.  However, the second derivative impact was just as meaningful.  The “Anything but California” trade took over amidst utilities, lifting already expensive low-risk utilities to higher levels.  Many investors got just as hurt by being short or underweight these names as being long CA.  With investors suffering and year end approaching, the last two weeks have showed signs of portfolios shrinking and extreme risk-aversion which has only exacerbated the problem.  Everyone needs a holiday.

The annual EEI conference will be held November 11-13.  Management from most of our covered companies will be there.  This report is a helpful guide for investors attending and includes questions to ask each company and summary model information.  Some of the industry topics we will be focusing on include:

Utilities rose 1.9% in October beating the market by 880bps.  This was the 9th best relative month for the sector since the S&P GICS were formed in 1995.  It was the second best in the last 17 years.  The month started with bond yields breaking out to a new 7-year high and we thought it would put the nail in the coffin for utilities.  But rising bond yields ended up killing the market instead while utilities actually rallied hard.  This defensive trade was evident in other sectors as well with Staples rising 2.1% for the month, slightly ahead of utilities.  We view this utility rally as a trick, not a treat.  Bond yields are still near 7-yr highs and would not be here if a recession was coming.  The relative valuation of the sector is well above average on both a P/E and yield basis.  We continue to recommend fading this rally.