For market bulls, it’s been tough to get excited about stocks so far this year.
Last Friday, the Nasdaq Composite Index and the Dow Jones Industrial Average closed in correction territory. And the S&P 500 Index booked the worst first week for a year in history, finishing down 6%.
The bears have certainly come out of their caves, proclaiming this lengthy bull market to finally be at an end. If you’re feeling rather ursine yourself and want to get short the market, here’s where you want to be.
Desperate Times – Desperate Measures?
In 2009, the Federal Reserve adopted its zero-interest rate policy (ZIRP) to spur economic growth in the wake of 2008’s devastating financial meltdown.
Since then, yield-starved investors have latched onto dividend stocks, particularly the defensive utilities sector.
These stocks pay better dividends and experience lower volatility than the broader market. But with rates so low, many utility firms borrowed heavily to upgrade their aging infrastructures. Today, an alarming number of these companies are leveraged up to their eyeballs.
As interest rates rise, profit margins will go down, and the cost of servicing debt will go up – and that means things are about to get ugly for utilities as we head into the latest interest rate hike cycle.
Among the victims will likely be the renowned Dividend Aristocrat, Consolidated Edison Inc. (ED).
Founded in 1884, Con Edison is one America’s oldest utility companies. It delivers regulated electric, gas, and steam to customers across the state of New York.
At the start of the ZIRP era, the company offered a fatter yield than both the S&P 500 and the benchmark 10-year Treasury notes. Shares also outperformed the broad market from the latter half of 2008 to 2013.
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But by 2013, Con Edison, along with its industry peers, had begun to lag the large-cap index considerably. And today, the stock appears prohibitively expensive.
The Devil Is in the Details
Because of the mad defensive rush into ED, the company’s forward yield dropped to 3.9%, compared to an average of 4.8% for its peers.
Shares currently trade at 16.2 times forward earnings, a 30% premium to its peers and a 10% premium to Con Edison’s 10-year median of 14.7.
Meanwhile, the company trades at more than nine times the enterprise value (EV) to forward EBITDA – a whopping 59% premium to peers.
EV is the sum of market capitalization and total debt, and this growing figure reflects a ballooning debt load, currently at $12 billion, that’s outpacing revenue growth.
Finally, Con Edison also trades at an 85% premium to peers on a price-to-forward cash flow basis. And speaking of cash, the company’s free cash flow has plunged 65% since 2011.
The near-term technical view on the stock isn’t any prettier.
Con Edison’s RSI is quickly approaching the overbought threshold. Shares also just bounced down from the major trend line resistance.
But the real damage is yet to be done. As the Fed hikes interest rates, income investors will flock from Con Edison to “safer” assets such as Treasuries and investment-grade bonds.
And even if the Fed delays further rate rises and the market rallies, the stock will likely continue to underperform the market.
Thus, it’s time to take the short side on these shares ahead of the imminent investor exodus.