XLU - UTG: Likely Already Bottomed - Buy On Pullbacks

Summary

• Reaves Utility Income Fund likely formed its significant bottom in October, despite the massive pessimism in Wall Street and the media. Also, analysts marked down their estimates through November.
• We highlighted that the panic in UTG had started in our previous article. We now discuss why it has likely bottomed out even though a recession has yet to hit.
• With the sharp mean-reversion recovery from its October lows, a pullback is likely. But, we encourage investors to be buyers on pullbacks and not be unduly concerned.

Thesis

In our previous article on the Reaves Utility Income Fund ( UTG ), highlighting that the panic had started, we urged investors to prepare for bear-hunting opportunities.

Amazingly, the market forced bearish UTF investors into a significant bottom in mid-October before recovering nearly 20% in price-performance terms (not including its distribution yield), outperforming the S&P 500 ( SPX ) (SP500). As such, brave investors who weathered the stormy panic and picked UTG's lows have been aptly rewarded, as the market forced weak holders to flee.

As we postulated, UTG's sharp mean reversion should not surprise investors, given the extent of the selloff from its August highs. We also highlighted that the leading constituents of UTG were no longer overvalued. Therefore, it also improved its reward/risk at its October lows.

Notably, we gleaned that UTG may have formed its long-term bottom in the current cycle even as the economy has yet to fall into the most widely-anticipated recession in recent times. In addition, we gleaned highly constructive price action from the Utilities Select ETF ( XLU ), which should corroborate the bottoming process in UTG.

Despite that, we gleaned that UTG's total return over the past 5Y and 10Y have fared worse than XLU's performance. Hence, the added volatility from its leverage has not provided the upside demonstrated in its performance over the past ten years.

Notwithstanding, we believe that investors who missed UTG's October lows should remain patient, as a pullback is looking increasingly likely after a sharp mean reversion.

We discuss why the market is looking ahead even though the media continues to inundate investors with recessionary themes.

Maintain Hold, but we encourage investors to be buyers on pullbacks.

Wall Street Has Turned Panicky

Interestingly, the market bottomed out in October ahead of the downward revisions by Wall Street in November, as seen above. Investors should bear in mind that the market is forward-looking, as utilities analysts marked down the sector's earnings projections through November.

Despite that, analysts remain optimistic that the sector could skirt a significant recession, as they expect the sector to post earnings growth of 5.7% over the NTM. Hence, we believe the projections may not have reflected severe recession risks. However, it's possible that such a dire outlook may not pan out, despite the highly pessimistic S&P 500's 2023 projections seen recently.

That's important as the market parses how long Fed Chair Jerome Powell and the FOMC would hold its terminal rate at the expected 5% level through 2023. Based on the revised consensus estimates, economists expect the rate to be held through the end of 2023 .

However, the reaction from the market at its October lows suggests that Wall Street analysts and economists could have been overly pessimistic. Edward Yardeni also articulated in a recent commentary:

We've said it before: If a recession is coming in 2023, it will be the most widely anticipated recession of all time. It would be the first time that we've collectively talked ourselves into a recession, and the bankers are among the most vocal pessimists, leading the way with their unsettling howling. So what are the bankers doing to prepare for their widely expected hard landing? Not much, so far, other than lending more money to their customers. [Also,] the [wage-inflation] spiral may be starting to decelerate. The Bureau of Labor Statistics reported that unit labor costs in the nonfarm business sector increased 2.4% (saar) during Q3, reflecting a 3.2% increase in hourly compensation and a 0.8% increase in productivity. Unit labor costs increased 5.3% y/y during Q3, which suggests that inflationary pressures on the CPI peaked during Q2. - Yardeni Research December 12 morning briefing .

Also, UTG Likely Bottomed Out

UTG formed a significant bullish reversal at its October lows on its long-term chart. The price action is similar to previous significant bottoms since its 2009 lows. Hence, despite the considerable pessimism in the media and Wall Street, we believe the market has signaled UTG bears that the worst is likely over.

A closer inspection of UTG's medium-term chart unveils the critical levels for investors to watch.

The mean-reversion rally from the panic selloff appears to have approached its near-term resistance, with further resistance at the 50-week moving average (blue line). Hence, the reward/risk is well-balanced, as we anticipate a potential pullback to improve the entry levels.

However, given UTG's significant October bottom, we don't expect October lows to be decisively broken. As such, we encourage investors to be buyers of UTG on pullbacks and not dwell excessively on the pessimism pandered by the media to spook investors.

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