It's been said that the only thing that separates humans from animals is our ability to recognize patterns. I'm not so sure about that. I've been watching my brother in law fall for one get rich quick scheme after another for more than 25 years now. I see a pattern. I'm not so sure he does.
Besides the ability to crunch numbers and look at a company's fundamentals, pattern recognition is invaluable in the investment racket. And when you work with certain stocks over a long period of time, you can't help but recognize patterns in their price behavior.
I live in the region serviced by utility behemoth Southern Company (NYSE: SO). Throughout my career as a financial advisor and writer, shares of Southern have been a staple in conservative portfolios. As one of the biggest regulated electrical utilities in the country, Southern has an outstanding operating history and is a steady dividend payer.
In my experience, it seems that people kind of collect the stock and hang on to it for what seems like forever.
However, forever can be a mighty long time.
Over the past few years I have noticed some interesting patterns in the price action of Southern shares. The price of the stock tends to experience one year runs of about 20% usually accounting for dividends which range in the 4%-5% neighborhood.
Looking at the chart, over the last four years the stock seems to peak in price around spring/summer. It then falls and then seems to bottom around October of the same year, setting itself up for the same upward pattern.
Even more interesting is the behavior of interest rates over the same periods. Here's a chart of the historic yield on the 10-year U.S. treasury.
In the spring/summer period of 2013, 2014, and 2015, interest rates did, indeed, rise while the price of SO fell. Why?
Ignore The Herd And Make Money With Utility Stocks
Historically, certain industrial sectors are sensitive to rising or falling interest rates. Utility stocks usually come under pressure as interest rates begin to rise. The reason for this is that the power generation business is extremely capital intensive and requires companies to rely heavily on debt financing to fund a portion of their operations. While the idea of high leverage might give some investors pause, the constant large cash flow that these companies typically generate is more than enough to comfortably service the debt.
But when interest rates rise, utility stock prices come under pressure. Investors fear that higher borrowing costs will hamper earnings and cash flow, thus they sell the stock.
Honestly, I think this fear is a little overblown. Electric utilities are highly regulated and the prices they charge their customers are usually stable to mildly rising. Utility company margins can come under pressure due to higher borrowing costs. However, in the ridiculously low interest rate environment we seem stuck in, this effect is probably negligible. But the herd usually has a mind of its own.
So, let's use the herd's infinite lack of wisdom make some money.
Over the time period I examined, SO shares rose around 18% not including dividends, from fall to spring/summer. Conversely, the yield on the 10-year treasury fell 12%. It looks like we're reaching that inflection point again with both the stock price and interest rates. In fact, the yield on the 10-year has fallen nearly 20% and Fed Chair Janet Yellen is hinting at another "normalization" of interest rates. The time for this trade may be ripe.
Risks To Consider: This scenario doesn't always play out. While it would seem the market is setting up for rising interest rates, signals have been mixed. Just as the Fed mulls raising rates, an extremely weak jobs report indicates that the U.S. economy may still be wheezing and sputtering, giving the Fed a signal to hold off. The stars may not line up correctly for this trade.
Also, selling shares of SO means giving up an attractive dividend yield. If you rely on your portfolio for steady income, you would be punching out of a highly reliable source.
Action To Take: If you are interested in trading and you have a decent profit in Southern Company, it's not a bad time to take the gain. Aim for around $50. If interest rates are poised to rise SO shares should fall back. Wait a while. A good re-entry price for the stock would be in the $42-$44 area. Waiting out the same cycle would result in a total return of 18% to 20% or more.
Editor's Note: If pulling down a yield of 10% a year sounds good -- before capital gains -- you need to see this. You'll find stocks paying 15.1%... high-yielding REITs, trusts, partnerships and ETFs. (These cash cows are also posting capital gains as high as +368% for us. I explain that part here.)