Junk bonds were the weakest part of the bond market, possibly because investors are starting to fear the solvency of corporate America once again, in light of the financial troubles hitting the airline industry. Some more leveraged companies – beyond just airlines – could have trouble eating the higher costs of energy for long periods of time.

(Published 09/01/05) One of the hottest fund categories over the last three years (ending 8/31/05) has been utilities. The three-year total return for the Dow Jones Utility index is a whopping 90% –double that of the S&P500 over the same time period. The typical mutual fund in this category scored a whopping 73% return. Our favorite in this category, the American Century Utilities fund (BULIX), which has appeared in several of our MAXadvisor Newsletter model portfolios, scored a 77.5% return over the same three-year period.

With investor excitement for utilities stocks at the highest levels since the days before the Enron debacle, we are finally downgrading utilities to a negative rating. We think utilities funds should underperform the market and 60% of stock fund categories in the next one to three years.

Utilities has been one of our favorite categories since we started the MAXadvisor Newsletter. From April 2002 through the end of January 2004 we gave the sector our highest rating (Most Attractive – should outperform the market and 80% of stock fund categories over the next 1 to 3 years). Then, for the next eight months, we maintained a positive rating (Interesting – should outperform the market and 60% of stock fund categories over the next 1 to 3 years). We then downgraded utilities to a neutral, and finally sold much of our utility stakes in our model portfolios a few months ago. But even after our downgrades, the funds in the category just kept climbing higher.

Despite the sector’s continued outperformance, we’re now more confident than ever that a utilities downturn is imminent. The only reason we’re not downgrading to our worst rating is that new utility funds are not sprouting up like mushrooms (new fund launches are one of the strongest contrarian signals of trouble ahead for a category), but existing utilities funds and ETFs are hugely oversold already. The iShares Dow Jones U.S. Utilities Sector Index Fund (IDU) has $800 million in assets. Our own favorite, Utilities SPDR (XLU), has an unbelievable $1.97 billion in assets.

For comparison, the Technology SPDR (XLK) – which is also a portfolio holding of ours – has around $1.3 billion. The only sector ETF with more money is the Energy SPDR (XLE), and we just slapped our worst rating on natural resource funds – the category energy falls under.

Can you imagine utilities funds being more popular than tech funds? Certainly not a few years ago. This is why utilities have doubled the market return in the last three years – nobody wanted anything to do with these during the dot-com bubble. Between Enron’s collapse and stories of over-leveraged, new-economy-style energy companies teetering on the edge of bankruptcy, the stocks had nowhere to go but up. The fact that a utilities index paid almost 6% in dividend yield didn’t entice anybody.

The ultimate buy sign was when Vanguard decided to convert their utility fund (one of the only good, low-fee funds around, our former top favorite and portfolio holding) into a plain-vanilla, dividend income fund. Vanguard did this in late 2002 because they couldn’t give away shares of a utility fund at the time.

But the category has now come full circle. This is not a good time to buy utilities funds. It is a good time to sell, which is what we’ve been doing all year in our newsletter and other portfolios. Performance has brought utilities stocks back to their pre-Enron levels, when utilities stocks were priced as if failure in their leveraged business models was impossible.
Worse, yields have fallen near proportionally with the rising prices (dividend increases haven’t come close to matching stock price appreciation). Today’s utility buyer is getting a dividend yield perhaps 1% over the S&P500 (3% instead of 2%) and about the same P/E ratio for owning heavily regulated businesses in one of the slowest growth and oldest economy areas around.

Sure, new home buying will lead to some growth, but come on, is your run-of-the-mill electricity utility going to grow earnings like other components in the S&P500 – like Pfizer, Wal-Mart, and Microsoft? Utilities are supposed to be cheap; they are a nice bond alternative that can perform better with inflation because dividends can go up with price increases, but that’s about it. Today’s utility fund buyer is looking at the near doubling over the last three years while ignoring the fact that utility stocks are going to have a tough enough time keeping pace with the market over the next few years (much less outperforming even more).

We’re sticking with our two lone favorites here largely because there are not too many compelling choices – at least since Vanguard made their utility fund disappear. Does Vanguard regret this move now? Maybe. They launched a couple utility index funds last year (their original utility fund was actively managed). The first was an ETF, Vanguard Utilities VIPERs (VPU), followed a few months later by one admiral class open-end fund with a $100,000 minimum, Vanguard Utilities Index Fund Admiral Shares (VUIAX). Both are fine alternatives to our picks below as well.

Most utilities funds are load funds because brokers need something to sell to widows and orphans and still land commissions since churning a stock account for those needing fixed income and low-risk could get them into trouble. What few utility funds are available without a load are fairly expensive. Since utilities should be bought primarily for yield, this is unacceptable. At the current paltry utilities yields, a 1.2% expense ratio quickly turns a utility fund dividend yield into an S&P500 index fund yield because fund fees are paid with dividends first.

We had our highest rating on down-and-out utilities back in 2002 and 2003. In 2004 the area was about the hottest this side of energy. Money keeps dumping into utilities stocks, and dividend yields are now paltry after even more big gains in stock prices in 2005 (beyond what we expected). Given the likely business growth, this is bordering on absurd. When interest rates move up this hot area is going to fall.

Category Rating: (Weak) – should underperform the market and 60% of stock fund categories

Previous Rating (08/31/05): (Neutral) - Should match the markets return and perform in the middle of other stock fund categories

Expected 12-month return:-2%

Investors tend to get something lodged in their head and latch on to it – sometimes to their peril. Making a reasonable assessment of risk is arguably the most important part of investing, closely followed by assumptions of possible returns. In simple terms, how much one can make compared to how much one can lose.

In this hunt for the unloved, we look at numerous factors. One way to help determine what broad style of investing to consider going forward is to look at what the biggest funds are doing.