Composition Changes Prompt Another Look at the DJ Utilities Average
Effective May 12, 1997, The Wall Street Journal made several changes in the Dow Jones 15 utilities average, with six utility issues dropped and six replacements:
The purpose of the changes was to revitalize the Dow Jones utilities average by adding some of the more actively traded issues. One result was that the “more desirable” stocks added were higher-priced, $42.33, on average, while the “less desirable” stocks dropped were lower-priced, $24.92, on average (based on May 9 closing prices).
The role of the utilities average was also discussed. The Wall Street Journal article noted that because utilities are big borrowers, they are interest-rate sensitive and therefore a leading indicator of interest rates, and, to some extent, a leading indicator to the overall market as well.
The debt-equity ratio for the utilities average is 103%. While a debt-equity ratio of 103% seems high, and maybe is significant, when compared to the average manufacturing company’s debt-equity ratio of 65%, the utilities’ debt-equity ratio is not so extraordinary. Nonetheless, swings in interest rates do enter the profit picture—and the stock price patterns—of utilities more than most other equities.
Utilities, since they offer above-average dividend returns and tend to be purchased by income-conscious investors, also will reflect the ebbs and flows of money returns. As interest rates rise, the payout on the utilities will become less attractive and prices will adjust downward, and vice versa.
At the time of the changes, the Dow Jones utilities’ yield was about 4½%, compared to the yield on the U.S. Treasury long-term bond of a little under 7%. As fixed-income returns rise or fall, the prices of utilities will subsequently fall or rise to keep pace.
The Sectors and the Market
However, the more interesting question for many stock market investors is: To what extent are the utilities a barometer for the stock market as a whole, and to what extent will changes in the utilities average precede important market swings?
After some years of observing the relationships, I would offer that in some circumstances the utilities average can add an important perspective to the market. Specifically, on the upside, the utilities average tends to either concurrently confirm or lag, but rarely lead. However, on the downside, the utilities average has preceded important market corrections. The relationship, though, is relatively loose, and thus the utilities average should only be used as a secondary tool, not a primary one.
The primary factor driving stock prices higher or lower is obviously earnings. Changes in interest rates will play a role in future earnings and dividend streams. However, interest rates are only one of many factors in the profitability model.
Indeed, because earnings drive the markets, the cyclical nature of the Dow Jones transportation average makes the transports much more important as a leading market indicator than the utilities, and most other indicators, as well.
During the choppy March-April period, investors were fretting over a variety of issues, including the likelihood of higher interest rates, the lagging nature of the much beloved small caps, the possible start of a bear market, etc.
However, as shown in Figure 1, the transports were giving a green light, not only by showing outstanding relative strength during the March–early April decline, but also by leading the market higher in mid-April. While most of Wall Street was fretting, preoccupied with opinions of why the market was going lower, the transports were saying the next market impulse would be up. The Dow Theory never worked better.
The utilities average, of course, finally got in gear and rallied.
Nonetheless, the utilities still represent an important market segment, and when the utilities are out of sync and are not confirming the rest of the market, it pays to keep a closer watch on any weakness that may develop in the overall market. While the utilities will not signal a “bear” market or a “bull” market, excessive weakness in the utilities will often precede a selling squall, usually a decline of at least intermediate importance.
Table 1 lists all periods over the last 10 years when the utilities had at least a 10% correction. A 10% correction is somewhat arbitrary, but I found that lesser corrections are not necessarily followed by important declines.
What investors will notice in the table, as well as in comparing Dow Jones utilities and the Dow Jones industrials over the last 10 years (Figure 2), is that when the utilities are in a “sell” mode—that is, the decline has been in the neighborhood of 10% or more—probabilities suggest that there eventually will be a significant shakeout in the overall market, or at least a period of limited market advance.
In addition, the longer and more extensive the decline in the utilities average, the more extensive the succeeding market volatility. In looking at Figure 2, notice that the most significant declines in the market have been preceded by a decline in the utilities that has had at least two legs lower, those years being 1987, 1990, and 1994.
In 1987, the utilities topped out in January 23 at 232.04, and the first down- leg carried the utilities to an April 14 low of 189.72. That particular utilities downleg of –18.2% resulted in a secondary correction in the industrials of 7.2% during the month of April.
After rebounding to a bear-market rally high of 214.91 on August 14, the utilities would then again begin to decline, starting on their second bear-market leg, eventually falling to 158.25 on October 19. The resulting “secondary” correction in the Dow Jones industrial average was –36.1%.
The years 1990 and 1994 were likewise two-leg declines in the utilities. After the industrials recovered from the volatility associated with the first downleg in the utilities, along came the second downleg in the utilities, with another corresponding decline in the industrials. The utilities “bear” markets that have two legs are much more devastating, and deceptive, than the one-phase versions.
Which brings investors up to 1997. The utilities during the first three months of the year posted a decline of 13.9%, and the market not surprisingly gave up 9.7% of its value.
During the first part of May, the utilities, led by the transports and then other market indexes, posted a nice rebound. A close-up view of 1997 (see Figure 3), indicates the resistance at 225-230 and why the rally stopped at that level.
By the time this article is read, the utilities average will have taken one of two possible courses. It could have successfully tested its lows and is confirming the other market indexes in moving higher. Or, the decline in the first three months of the year was only the first leg of a major bear market in the utilities, as the utilities once again decline below their April lows at around the 210 level. The development of a second leg in a utilities bear market would have very negative implications for the overall market.
The Dow Jones utilities average cannot be used to “fine-tune” the market. However, some of the more volatile markets develop after a period of time when the utilities average has been moving lower, both in terms of points and time. So, when the utilities average is in a “sell” mode, it is time to keep your cards close to your vest.