The risk of investing in the utilities sector is less than the broader market. The two main reasons are the high dividends in the utility sector and its relatively recession-proof business. While risk is decreased in the utilities sector, it is also likely to underperform the market during bull markets. Due to this behavior, utilities are considered the ideal defensive sector. Utility stocks tend to perform best late in the business cycle when growth begins to slow and during periods when interest rates are declining.
Catalysts for Utility Stocks
Defensive sectors tend to outperform when investors become concerned about a slowing economy. Utility stocks' revenues are not affected by changes in the economy, and their high dividends become appealing when downside risks accumulate. Further, central banks respond to a slowing economy by cutting interest rates, which is a positive catalyst for dividend-paying stocks.
Great Recession Stress Test
The Great Recession in 2007-2008 exemplified the safety of utilities during a market downturn. Based on the logic detailed above, investors expected the sector to outperform the broader market, and then underperform when the bull market resumed.
Like all sectors in the stock market, it experienced selling pressure, falling 40% from its high in October 2007 to the bottom in March 2009. However, during this period, the sector also paid out 6% in dividend yields, providing investors with income during this period of uncertainty. In contrast, the S&P 500 was down more than 60% from peak to trough and paid out 2.5% in income.
When the stock market recovered and went on to new highs, the utilities sector improved as well. While the S&P 500 more than tripled between March 2009 and June 2015, the utilities sector was up 140%. This lack of exposure to improving economic conditions is certainly a risk that investors in the utilities sector need to keep in mind.