Merrill Lynch quantitative strategist Savita Subramanian has a new trade idea – sell U.S. utility stocks and buy U.S. financial stocks – for a potential gain of 20 per cent in the next 12 months. Could this trade also work for Canadian stocks?
The answer, while not unequivocal, is a likely yes, although with lower potential returns.
Ms. Subramanian’s rationale for financials versus utilities in the U.S. market is based primarily on relative valuations.
Using price-to-forward earnings (stock prices divided by consensus analyst earnings forecasts for the coming year), U.S. utility stocks are currently trading at a 60-per-cent premium to financials, the strategist said in a research note Monday. This is more than two standard deviations above the average relative valuation, and the fourth-highest premium for utilities in the past three decades.
These extremes in valuations for utility stocks relative to financials have occurred eight times since 1986. In seven out of eight times, a long-financials/short-utilities trade outperformed the S&P 500 in the next 12 months and the average return was 19.7 per cent.
The big limitation in assessing the viability of the trade idea for Canadian equities is the availability of data. Merrill Lynch analyzed more than 30 years of market history, while only 17 years of forward price-to-earnings ratios are at hand for domestic utility and financial stock indexes.
That caveat aside, it’s clear that the S&P/TSX Capped Utilities Index is extremely expensive relative to the S&P/TSX Capped Financials Index, according to their respective P/Es. Utility stocks are currently trading at an 85-per-cent premium to financials, well above the 17-year average of 53 per cent and almost exactly 1.5 times the historical standard deviation of 0.57.
I checked relative returns – financials minus utilities – for the 12 months after every instance when utilities were trading with forward price-to-earnings ratios 85 per cent or more higher than financials, as they are now. On average, financials outperformed utilities by 13.2 per cent, not including dividends in either case.
That is an impressive number, but it hides a lot of variance and shouldn’t be taken without a big grain of salt. From November, 2008, until March, 2009, for instance, the viability of the global financial system was threatened and financials traded at extraordinarily discounted valuation levels. Because the postcrisis market rally began in March, 2009, financials that had been dirt cheap from the previous November outperformed utility stocks by an average of 33 per cent in the next year, skewing the overall average higher.
Conversely, there have been times when deeply discounted financial stocks failed to outperform utilities. In September and October of 2015, financials were discounted, but still underperformed utilities by 2.5 per cent on average in the subsequent 12 months.
The accompanying chart shows a consistent relationship between performance and valuation for financial and utilities stocks over the past 17 years. When utilities stocks are trading with a P/E ratio premium of less than 50 per cent relative to financials, the financial stock performance is either similar or lower than utility stocks in the next 12 months. But when the premium gets above 50 per cent, financial stocks consistently outperform utilities.
The sector-specific ETFs that would allow investors to execute the short-utilities/long-financials trade are available, but I’m not at all suggesting that they do so. The performance histories aren’t long enough to generate the necessary confidence. There are market factors, demographics and stubbornly low interest rates, in particular, that might increase the attractiveness of the higher income streams from utility stocks more so than in the past.
The recognition that utility stocks are at extreme levels relative to financial stocks is, however, relevant for investors putting new money to work in their portfolios. The odds are slanted heavily in favour of financial stocks outperforming in the coming years.
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Average Financials performance
When utility stocks are expensive relative to
financials, they tend to underperform in the
next 12 months
30%
25
20
15
10
5
0
-5
-10
-15
-50% -
-25%
-25%
- 0
0 -
25%
25% -
50%
50%-
75%
75%-
100%
100%
and
higher
S&P/TSX Capped Utilities Index P/E to
S&P/TSX Capped Financials Index P/E
(valuation, percentage premium)
JOHN SOPINSKI/THE GLOBE AND MAIL
SOURCE: scott barlow; bloomberg
Average Financials performance
When utility stocks are expensive relative to financials,
they tend to underperform in the next 12 months
30%
25
20
15
10
5
0
-5
-10
-15
-50% to
-25%
-25%
to 0
0 to
25%
25% to
50%
50% to
75%
75% to
100%
100%
and
higher
S&P/TSX Capped Utilities Index P/E to S&P/TSX Capped
Financials Index P/E (valuation, percentage premium)
JOHN SOPINSKI/THE GLOBE AND MAIL
SOURCE: scott barlow; bloomberg
Average Financials performance
When utility stocks are expensive relative to financials, they tend to underperform
in the next 12 months
30%
25
20
15
10
5
0
-5
-10
-15
-50% to
-25%
-25%
to 0
0 to
25%
25% to
50%
50% to
75%
75% to
100%
100%
and higher
S&P/TSX Capped Utilities Index P/E to S&P/TSX Capped
Financials Index P/E (valuation, percentage premium)
JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow; bloomberg
Scott Barlow