Billionaire investor and “Bond King” Jeffrey Gundlach, CEO of DoubleLine Capital, has unleashed a can of whoop-ass on the investment allure of the “Magnificent Seven” technology stocks. In this article, we plumb the depths of his concerns and size up a rip-roaring alternative with fantastic risk-adjusted appeal: the Utilities Select Sector SPDR® Fund ETF (NYSEARCA:XLU).
The Wrath of the Bond King Against the Magnificent Seven
The Magnificent Seven – featuring Apple (AAPL), Amazon (AMZN), Alphabet (GOOGL)(GOOG), Meta Platforms (META), Microsoft (MSFT), Nvidia (NVDA), and Tesla (TSLA) – have been on a tear, fueled by the AI explosion stemming from the rapid growth of generative AI products like ChatGPT. These 7 stocks have packed a wallop, chalking up roughly three-quarters of all the S&P 500 (SPY)(VOO) gains in 2023 so far. While this performance has certainly been mind-blowing, past performance is no guarantee of future results. Yet, Mr. Gundlach seems particularly worried about the potential of these companies to sustain their white-hot streak, declaring 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 bearish stance stems from the current murky economic climate, with Gundlach foreseeing a recession by the second quarter of 2024 and the Federal Reserve likely to drag its feet on interest rate cuts for as long as possible, putting a strain on the economy as borrowing costs stay elevated even as consumer spending power wanes and overleveraged businesses begin to see earnings drop sharply. Moreover, Gundlach points out the super low equity risk premium in today’s market, hinting that U.S. equities – increasingly dominated by the Magnificent Seven due to their colossal market capitalization – are seriously overvalued and have limited short-term growth potential.
As a result, Gundlach believes investors should steer clear of SPY and VOO, capitalization-weighted funds that are heavily overweight the mega-cap “Magnificent Seven,” and instead pour their money into funds with more diversification in non-market leaders and companies that are robustly positioned to survive a brutal economic atmosphere.
Why XLU ETF Is an Absolute Knockout Right Now
Considering Gundlach’s outlook alongside our belief that bond yields are going to keep dropping in the coming year, utility stocks – especially XLU – look like a real catch right now on a risk-adjusted basis. Here’s why:
1. Favorable Macro Environment
Utility stocks typically shine in a downturn and falling interest rate environment due to several inherent characteristics.
First off, utilities offer essential services like electricity, water, and gas, which are indispensable for both individuals and businesses, no matter the economic climate. This inelastic demand ensures a steady revenue stream for utility companies, making them less vulnerable 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.
Secondly, 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 dwindle with interest rates, utilities become more enticing for their ability to deliver a consistent income stream, propelling their stock prices higher and leading to outperformance relative to other stock market sectors.
Lastly, utilities are capital-intensive businesses that often finance their infrastructure investments by raising capital. In a falling interest rate environment, the cost of borrowing goes down and equity valuations frequently rise, making it cheaper for utilities to bankroll 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. Tempting Valuation
Right now, utility stocks come with a pretty irresistible price tag. As the chart below shows, XLU has dipped by ~20% over the past 15 months due to surging interest rates:
As a result, a change in the interest rate narrative could send XLU’s valuation multiples significantly higher, driving robust total return performance. Furthermore, this means that the headwinds from higher interest rates are largely already baked into utility stocks, meaning that even if interest rates do stay higher for longer, the downside risk isn’t substantial compared to the upside potential if macro factors turn more favorable down the road.
3. Low Cost Fund
Another reason we really dig XLU as a bet on waning interest rates and a softening economy moving forward is because investors shell out very little in management fees to the fund manager, with a low expense ratio of just 0.10%. The fund also commands nearly $14 billion in assets under management, providing loads of liquidity and super low spreads when buying and selling shares:
As a result, it’s a highly efficient vehicle for investing in the utilities sector.
4. Rock-Solid Diversification
Lastly, XLU is also an enticing, risk-tailored wager right now because it offers investors effortless and significant diversification, helping to cushion 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, with its top holdings including 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).
Amidst a dicey economic outlook and the increasing threat of a recession, Jeffrey Gundlach’s prudent advice on steering clear of the “Magnificent Seven” technology stocks and our certainty that interest rates are on a downward trajectory in the near term makes us view the utilities sector as an especially tantalizing investment contender right now. While we’re stocking up on individual high-yielding and deeply undervalued utilities at present, investors who seek a straightforward, efficient, and well-diversified exposure to the sector might find XLU to be a seductive option currently offering a very attractive risk-reward setup, especially in comparison to mega-cap tech stocks and mega-cap dominated ETFs like SPY and VOO.