Over the past month, as shown by the chart below, despite all-time highs in equity indices, utility stocks have been under selling pressure.
This should not come as a complete surprise given the defensive nature of the industry. However, it should be noted that prior to this recent sell-off the utility sector had been among market leaders, not laggards. There are a few reasons behind the sector-wide sell-off:
1. Increasing interest rates.
The recent rise in interest rates is a negative for utility stocks because utility stocks tend to be among the highest yielding in the market. Higher yielding bonds serve as better competition to utility stocks.
2. Defensive nature
Investors have likely started rotating into more cyclical stocks as data continues to suggest an improving economy. Utilities will not benefit much from an improved economy, and thus investors are likely betting that there are better places to be invested.
3. High valuations
Generally speaking, as shown by the chart below, many of the utility stocks such as Consolidated Edison, Inc. (NYSE:ED), Dominion Resources, Inc. (NYSE:D), and Public Service Enterprise Group Inc. (NYSE:PEG) have been trading close to their historic high valuations. Given this, it makes sense that investors are selling at these valuations to move into other sectors.
ED Forward PE Ratio data by YCharts
Johnson & Johnson (NYSE:JNJ) is a likely candidate to follow utility stocks lower. Much like a utility, J&J pays a healthy divided (currently 3%) and has attracted income-seeking investors. Due to this, it is not unreasonable to expect J&J to come under some selling pressure as interest rates rise. Also, J&J is a defensive name with minimal exposure to economic trends. Finally, as shown by the chart below, J&J is also trading at historically high valuations.
JNJ Forward PE Ratio data by YCharts
The Hershey Company (NYSE:HSY), like Johnson & Johnson (NYSE:JNJ), is a likely candidate to follow utility stocks lower. Hershey used to be a high yielding stock but the recent share price rally has left the stock with a dividend yield just below 2%. That being said, given the historically low interest rate environment, I would still say that Hershey is impacted by a rise in rates as the dividend is less attractive relative to bonds. Like J&J and utilities, Hershey is a defensive name given that its business has relatively little exposure to economic trends. Finally, as shown by the chart below, Hershey is trading at high valuations relative to its historic norms.
HSY Forward PE Ratio data by YCharts
Reynolds American, Inc. (NYSE:RAI) is also a likely candidate to follow utility stocks lower. Much like a utility, Reynolds American pays a healthy divided (currently 5%) and has attracted income seeking investors. Due to this, it is not unreasonable to expect Reynolds American to come under some selling pressure as interest rates rise. Also, Reynolds American, one of the largest tobacco companies in the world, is a defensive name with minimal exposure to economic trends. Finally, as shown by the chart below, Reynolds American is trading at historically high valuations.
RAI Forward PE Ratio data by YCharts
Conclusion
Utility stocks seem to be the first group of defensive stocks to lose ground as the stock market bull continues to mature. I expect that other defensive stocks will soon come under pressure as investors react to rising interest rates, an improving economy, and rich valuations. Given their status as dividend payers, non cyclical stocks, and high valuations Johnson & Johnson, Hershey, and Reynolds American are all names to be cautious on given the current environment.
Sammy Pollack has no position in any stocks mentioned. The Motley Fool recommends Dominion Resources and Johnson & Johnson. The Motley Fool owns shares of Johnson & Johnson.
The article After A Utility Sell-Off These Three Stocks Could Be Next originally appeared on Fool.com.
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