The last time we traded the Utilities Select etf (XLU) was back in late December 2014 when the etf was approaching new all time highs, up 30% on the year, and by far the best performing sector in the S&P 500 (here), from Dec 26th 2014:
Now flash forward 9 months, while Energy is still the worst performing sector in the S&P 500, the XLU has flipped to the bottom third as far as performance (or lack there of):
As the FOMC nears their first rate increase in 9 years, it makes sense that high yielding defensive sectors might be sold off in advance, as Utilities have, but whats curious to me is that the yield on the 10 year Treasury is nearly in the exact same spot as it was in late December, when the XLU was at its then all time highs:
So why would the XLU be trading at its 52 week lows if the Treasury Yields and Fed Funds futures don’t speak to a meaningful rise in interest rates any time soon? Just as I felt in late December that the rally in Utilities did not adequately reflect investors perceptions of the rate environment and related investment opportunities, I feel similarly now as the etf now approaches key technical support at $40, down 17% from the 52 week highs:
A quick look at the 10 year chart of the XLU shows just how important this recent pullback is in terms of the long term uptrend from the 2009 lows, its held like a boss!
Now lets look out to next week’s FOMC meeting. I have no idea what the Fed is going to do. To raise or not to raise?? I suspect they don’t exactly know what they are going to do yet either. But many believe if they do raise it will merely be symbolic and will not exactly suggest we will see interest rates move too much higher any time soon. If the FOMC does not raise it likely means that they will do so in Oct or Dec, but again likely to be a one off thing as the macro situation appears precarious at best, outside the U.S.
So from where I sit, a rate increase next week by the FOMC might already be priced in to credit markets here in the U.S., and if they don’t raise its because of a sincere worry about macro deteriorating, either way, a sector like XLU which has been re-rated in 2015, the fat dividend yields and 100% exposure to the U.S. could once again cause investors to view the sector as attractive and defensive.
Much like the rest of the market though, options prices have risen fairly dramatically of late, and long premium directional strategies could be a tough way to make money if vol were to settle:
Recognizing that vol is high, its important to note that out of the money calls also look dollar cheap. The etf goes ex-dividend on Sept 18th, estimate is 42 cents.
Given the etf’s 10% decline in the last month I suspect after the FOMC decision we could see a sharp re-tracement of half of the recent move lower in XLU.
Trade: XLU $41.40 Buy Oct 42/44 call spread for .50
-Buy to open 1 Oct 42 call for .60
-Sell to open 1 Oct 44 call at .10
Break-Even on Oct Expiration:
Profits: between 42.50 and 44 of up to 1.50, max gain of 1.50 above 44, up 6%
Losses: up to .50 between 42 and 42.50, max loss of .50 below 42
Rationale: Utilities look poised to move given the rate catalyst in the coming week, and given the technical set up. While options in XLU are expensive in vol terms, they look cheap in dollar terms. I like the risk reward for long premium bullish trades in the near term.