XLU - Billionaire Jeffrey Gundlach Says Sell The Magnificent Seven: Buy XLU Instead

2023-12-06 07:05:00 ET

Summary

• A highly regarded billionaire investor recently voiced a bearish outlook on the magnificent seven and market cap-weighted ETFs like SPY and VOO that hold them.
• Instead, he believes that diversification into more defensive and increasing relative exposure to smaller-sized companies makes sense right now.
• We share why we think that XLU is a very attractive pick instead of the magnificent seven right now.

Billionaire investor and "Bond King" Jeffrey Gundlach, CEO of DoubleLine Capital, has recently voiced his concerns about the investment appeal of the "Magnificent Seven" technology stocks. In this article, we look at his concerns and examine a very attractive risk-adjusted alternative: the Utilities Select Sector SPDR® Fund ETF ( XLU ).

Why The Billionaire Bond King Doesn't Like The Magnificent Seven

The Magnificent Seven - consisting of Apple ( AAPL ), Amazon ( AMZN ), Alphabet ( GOOGL )( GOOG ), Meta Platforms ( META ), Microsoft ( MSFT ), Nvidia ( NVDA ), and Tesla ( TSLA ) - have had a tremendous year, fueled by the artificial intelligence boom caused by the rapid growth of generative AI products like ChatGPT. As a result, these 7 stocks have generated roughly three-quarters of all the S&P 500 ( SPY )( VOO ) gains in 2023 so far. While this performance has certainly been extremely impressive, past performance is no guarantee of future results and Mr. Gundlach seems particularly concerned about the ability of these companies to sustain their strong run, stating recently that:

They will obviously be the worst performers in the upcoming recession. Whatever is leading the charge going into the economic downturn invariably must lead the charge on the way down. I would get out of them.

His bearishness is rooted in the current uncertain economic climate, as Gundlach anticipates a recession by the second quarter of 2024 and the likelihood that the Federal Reserve will delay interest rate cuts for as long as possible, which will put considerable strain on the economy as borrowing costs remain elevated even as consumer purchasing power begins to fade and overleveraged businesses begin to see earnings drop meaningfully. Moreover, Gundlach points out the extremely low equity risk premium in today's market, suggesting that U.S. equities - which are increasingly dominated by the Magnificent Seven due to their huge market capitalization - are meaningfully overvalued and have limited short-term growth potential.

As a result, Gundlach believes investors should steer away from capitalization-weighted funds like SPY and VOO, which are heavily overweight the mega-cap "Magnificent Seven" and instead invest in funds with greater diversification in non-market leaders and companies that are well-positioned to weather a challenging economic period.

Why XLU ETF Is A Compelling Buy Right Now

Given Gundlach's perspective alongside our expectation that bond yields are likely going to keep falling in the coming year, utility stocks - and XLU in particular - look quite attractive right now on a risk-adjusted basis. Here is why:

1. Favorable Macro Environment

Utility stocks typically outperform in a falling interest rate and recessionary environment due to several inherent characteristics.

First, utilities provide essential services like electricity, water, and gas, which are necessary for both individuals and businesses, regardless of the economic climate. This inelastic demand ensures a steady revenue stream for utility companies, making them less susceptible to economic downturns. Unlike discretionary spending that fuels the earnings of Magnificent Seven companies like AMZN, AAPL, and TSLA - which can fluctuate dramatically during a recession - the demand for utility services remains relatively constant.

Second, during periods of falling interest rates, income-seeking investors often turn to utilities for their high and stable dividend yields. As yields on fixed-income securities like bonds decline with interest rates, utilities become more attractive for their ability to provide a consistent stream of income, driving their stock prices higher and leading to outperformance relative to other sectors of the stock market.

Third, utilities are capital-intensive businesses that often finance their infrastructure investments by raising capital. In a falling interest rate environment, the cost of borrowing decreases and equity valuations often increase, making it cheaper for utilities to finance their operations and expansion projects. This lower cost of capital not only improves their margins but can also enable them to invest in more growth opportunities.

2. Attractive Valuation

Utilities stocks are also quite attractively priced right now. As the chart below illustrates, XLU is down by ~20% over the past 15 months due to rising interest rates:

As a result, a shift in the interest rate narrative could push XLU's valuation multiples meaningfully higher, driving strong total return performance. Moreover, this means that the headwinds from higher interest rates are largely already priced into utility stocks, meaning that even if interest rates do remain higher for longer, the downside risk is not material compared to the upside potential if macro factors become more favorable moving forward.

3. Low Cost Fund

Another reason we really like XLU as a way to bet on a declining interest rate and weakening economic environment moving forward is because investors pay very little in management fees to the fund manager given that it has a low expense ratio of just 0.10%. The fund also has nearly $14 billion in assets under management, giving it plenty of liquidity and very low spreads when buying and selling shares:

As a result, it is a very efficient vehicle for investing in the utilities sector.

4. Strong Diversification

Finally, XLU is also an attractive risk-adjusted bet right now because it offers investors easy and significant diversification, helping to hedge a utility bet against weather, balance sheet, capital allocation, project execution, and regulatory decision risks that often plague individual utilities. XLU holds 31 utilities overall, and its top holdings consist of blue-chips: NextEra Energy Inc ( NEE ), Southern Co ( SO ), Duke Energy Corp ( DUK ), Sempra ( SRE ), American Electric Power Co Inc ( AEP ), Dominion Energy Inc ( D ), Exelon Corp ( EXC ), Constellation Energy Corp ( CEG ), PG&E Corp ( PCG ), and Xcel Energy Inc ( XEL ).

Investor Takeaway

Amidst an uncertain economic outlook and the growing potential for a recession, Jeffrey Gundlach's cautious view on the "Magnificent Seven" technology stocks and our conviction that interest rates are likely headed lower in the near term makes us view the utilities sector as a particularly compelling investment option right now. While we are loading up on individual high-yielding and deeply undervalued utilities at the moment, investors who want a simple, efficient, and well-diversified exposure to the sector may find XLU to be a compelling option at the moment that we think offers a very attractive risk-reward profile, especially relative to mega-cap tech stocks and mega-cap dominated ETFs like SPY and VOO.

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