“I have only one eye, I have a right to be blind sometimes… I really do not see the signal!” – Horatio Nelson

Are you a stock investor but love bonds? It turns out that the Utilities sector is the equity play on fixed income. Not only do Utilities tend to have high dividend yields, but they also tend to exhibit lower volatility and beta than the vast majority of sector and industry groups out there. Why? Because no matter what, you always need to turn that light on. Always need to cook that food. No matter what kind of economy you’re in, Utility companies tend to have inelastic demand, which is just a fancy way of saying that people will use those products and services regardless of his or her current income situation.

Historically, a significant portion of a Utility company’s total return is built on that dividend yield as opposed to capital appreciation of stock price. During highly uncertain times for the economy and the market, investors flock to that perceived yield “safety” as interest rates drop with growth and inflation expectations. Utility companies from a fundamental perspective benefit when rates fall.Why? Because Utility companies tend to be highly leveraged to maintain their infrastructure, and need to keep rolling over their debt for business continuity. Rates falling are then a cost savings as that debt continuously rolls over into whatever the lower cost of capital ends up being.

But Utilities are not just a way to play bonds if you invest in stocks.Utilities aren’t just a place to run to if you’re hungry for yield. Utilities are also a signal for coming stock market volatility. In the 2014 Dow Award winning paper “An Inter-market Approach to Beta Rotation” I co-authored (click here to download), we show that going back to the late 1920s, when in the short-term the Utilities sector outperforms the broader stock market, on average stock market volatility and drawdown risk for equities rises afterwards with a lag. It turns out then that Utilities (like moving averages) can be seen as a leading indicator of risk for equities.We show that if you created a relative momentum “Beta Rotation Strategy” (BRS for short) either going fully into Utilities or fully into the broader stock market based on near-term leadership, it turns out that when Utilities are leading, stock market volatility is higher on average afterwards.

Why is this the case? We speculate that because Utilities are “the” safety sector for stock investors and are most sensitive to changing growth and inflation expectations for the broader market, their movement likely has information that broad market participants would find important in assessing the future health of the financial market. Of course this does not mean that every single time Utilities are outperforming the market in the short-term that stocks will experience a correction or decline, but rather that the odds have tilted towards a riskier period ahead.

A good example of this? The middle of the below chart shows the price ratio of the Utilities Select Sector SPDR ETF (XLU) relative to the Vanguard Total Market VIPERs ETF (VTI). A rising ratio means Utilities/XLU is outperforming (up more/down less) the stock market/VTI. In the context of our research, this near-term strength (uptrend in the ratio) in stocks would suggest risks going forward for equities are rising. This clearly was the case in 2012, where below the ratio one can see both the S&P 500 Index and the VIX Index as well. Two major corrections, two major periods of volatility, and two major warning signs that Utilities gave to watch out ahead before it was too late.

(Click on image to enlarge)

Bottom line? While many are attracted to Utilities for their relative safety and yield, the sector represents much more than an investment opportunity. It also serves as an important indicator for risks ahead. And while the last few years it has appeared with hindsight that markets have had little to no risk given the strength of the bull market and crush of volatility, cycles do change, and Utilities might be just the area to watch for danger ahead.