By Jim Donnelly, Olson Global Markets

Although taking some time to develop, the Dow Jones Utility Index (DJU) appears to be setting up for a solid move upward. A bullish “reverse head & shoulders” pattern that has been in the making since the post-Lehman Brothers plunge in October 2008 continues to form, targeting a potential move up to the 525 area.

Fostering this technical viewpoint is an apparent fundamental thirst for yield. Persistent pressures from pension plans, retirees, college endowments and others who rely on interest and dividends for their day-to-day needs are finding low yielding U.S. Treasuries, intermediate-term CD’s and money market accounts extraordinarily stingy.

While a good number of investors continue to tout their preference for the “return of their capital”, rather than “return on the capital”, others are becoming weary of that standpoint. As a result, there is a growing chorus of advisors that point out that many S&P 500 common stocks, including utilities, are paying higher dividend yields than are 10-year U.S. Treasury notes.

Because the balance sheets of most utility companies are typically laden with debt, the worry has been that rising interest rates would not only compete with yields on their common stocks as an investment vehicle, but would also become more costly to them as they routinely refinance their outstanding debt if in a rising rate environment.

Following Friday’s disappointing employment data, as well as Goldman’s Sachs’ forecast for the unemployment rate to inch up to 10% into 2011 and stay there for the remainder of the year, the expectation for interest rates to rise has once again been muted. In addition, a potential decline in interest rates could result in lower debt costs to utility companies, That, in turn, should make those who thirst for yield to take a harder look at utility common stocks.

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By Jim Donnelly, Olson Global Markets

In light of the sunset provision in the law that had reduced taxes on dividends and capital gains during the Bush Administration, one might expect a reduced enthusiasm to own dividend paying stocks going forward. The Obama Administration, however, appears likely to align tax rates on both dividends and capital gains to 20% from the current 15%. Although not yet voted on by Congress, this is much less ominous than the concern that they could rise to 39.6% and 20% respectively.

Another factor to consider is the growing notion that austerity measures being taken in Europe and in many States and municipalities through the U.S. will result in a prolonged non-inflationary slow-growth period. If so, income producing vehicles of all kinds should remain in focus, particularly for cash starved pension plans and retirees who rely on interest and dividends for their day-to-day needs.

This assessment could be why the Dow Jones Utility Index (DJU) appears to be forming a bullish reverse Head & Shoulders pattern on weekly bar charts. Interestingly, a very similar pattern formed during 2002 and 2003 at lower levels that corresponded with a higher inflation environment.

In this case, a break above “neckline” resistance at the 408 level could lead to a solid extension up to the 525 area on the Dow Jones Utility index. Near-oversold conditions are currently present, which suggests that a move of that magnitude is clearly possible.

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Utility prices are sometimes seen collectively as a barometer of the direction of interest rates since utility companies are big borrowers of debt. If interest rates decline, their costs decline which becomes a big plus for utility stock prices. As a result of this relationship, utility prices are often seen as a leading indicator of equity prices in general.

With that in mind, it is worth noting that the Dow Jones Utility Index (DJU) has seemingly found key resistance at the 408.50 level (where key “cross” trend line sits) after having rallied from the 288.66 March 2008 low. With overbought technical readings on weekly charts now present, and with growing expectations of a rise in interest rates finding some traction, such a stall in the DJU Index is understandable.

A downturn in utility stock prices, if it occurs, would likely mute the bullish tone for both the Dow Jones Industrial index and the S&P 500 Index if the 408.50 continues to hold as key resistance. On the other hand, a solid break above 408.50, if it occurs, would be very positive for equity prices, particularly if the financial sector follows through to the upside. It would also suggest that recent expectations for a rise in interest rates may be misplaced.
For the time being, however, bullish sentiments for equity prices will likely be put on hold until a solid break above the 408.50 resistance area on the DJU index occurs.

Jim Donnelly, Olson Global Markets

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by Jim Donnelly, Olson Global Markets

With a 15% to 20% reduction in demand for electricity and other power needs, the Dow Jones Utility Index already suffered a 48% plunge from its January 11, 2009 high of 555.71 to the 288.60 low set on March 9th. Since then, it has rebounded by 18.5% to Friday’s 342.20 close.

The question is whether the 288.60 “low” set on March 9th was THE “low”. If limp economic activity was not enough to worry about, serious concerns over “cap and trade” issues have added another negative dimension to the utility sector. If implemented “cap and trade” would act as a tax on carbon emissions which would likely result in higher utility costs to consumers, and squashed profit margins to providers.

Other factors also cast a cloud over the prospects for utility production. Levered up balance sheets, which are plentiful in this arena, are troubling to investors since the ability to “roll over” debt at maturity could become a threat, particularly in the current market environment.

Increased concerns over consumers’ reaction to the prospect of higher utility costs, on the other hand, could turn “cap and trade” into a political nightmare and force a very important “re-think”. Another positive circumstance for utilities should come from the “lagged effect” of huge fiscal stimulus that has already been set into motion. That “effect” should “kick in” later this year which, in theory, should help stem the decline of economic activity and provide a floor for utility usage.

Technically, the long-term chart of the Dow Jones Utility Index suggests that it may have found support at 288.60 where long-term “channel bottom” support sits (in blue). In addition, “cross” trend line support (in green) intersected at 288.60 as well. Lastly, the decline from high to low came by way of an Elliott 5-wave structure. If that assessment is correct, a minimum 38% retracement up to 393 should continue to unfold. That would represent another 15% move to the upside from here. Bullish technical divergences support such an outlook over the intermediate term. Higher levels are possible particularly since “mid channel” resistance sits in the 450 area. Still, a 15% extension higher seems to be a reasonable expectation…for now.

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