Utility ETF Set To Breakout

In his most recent commentary, PIMCO's Bill Gross provides his rationale to invest in utility stocks.

Gross suggests that the Federal Reserve will remain accommodative for a very long time:

"Raise interest rates with 15 million jobless and 25 million part-time working Americans? All because gold is above $1,100? You must be joking or smoking – something. We will need another 12 months of 4-5% nominal GDP growth before Bernanke and company dare lift their heads out of the 0% foxhole – mini-bubbles or not."

Why is the Fed doing this?:

"The Fed is trying to reflate the U.S. economy. The process of reflation involves lowering short-term rates to such a painful level that investors are forced or enticed to term out their short-term cash into higher-risk bonds or stocks."

And there is the rub. There is no safe place to park your cash money. As Gross asks with a series of questions:

"OK, so where does that leave you, the individual investor, the small saver who is paying the price of the .01%? Damned if you do, damned if you don’t. Do you buy the investment grade bond market with its average yield of 3.75% (less than 3% after upfront fees and annual expenses at most run-of-the-mill bond funds)? Do you buy high yield bonds at 8% and assume the risk of default bullets whizzing at you? Or 2% yielding stocks that have already appreciated 65% from the recent bottom, which according to some estimates are now well above their long-term PE average on a cyclically adjusted basis?"

So Gross concludes that utilities with their high yields, fair performance year to date, and likely in line growth with the US economy would be a good place for his money:

"Why not just buy utilities if that’s what the future American capitalistic model is likely to resemble. Pricewise, they’re only halfway between their 2007 peaks and 2008 lows – 25% off the top, 25% from the bottom. Their growth in earnings should mimic the U.S. economy as they always have, and most importantly they yield 5-6% not .01%! In a low growth environment, it seems to me that a company’s stock should yield more than its less risky debt, and many utilities provide just that opportunity. Utilities and even quasi-utility telecommunication companies now yield between 5 and 6%, whereas their 10- and 30-year bonds yield less and at a higher tax rate to you the investor."

Now let's take a look at the S&P Select Utilities Spider Fund (symbol: XLU). See figure 1 a weekly chart. The indicator in the lower panel measures the distance between the upper and lower Bollinger Bands; this value is wrapped in trading bands that looks for statistically significant extremes. The difference between the upper and lower Bollinger Bands is a measure of volatility. Prior to (up or down) breakouts, prices will typically move in a range as buyers and seller become in balance. Price range or volatility will contract. This is what the indicator measures. As prices contract, the bands narrow. When prices breakout (to the upside for example) buyers overwhelm the sellers, price and volatility expand. The Bollinger Bands widen. Viola, the breakout!

Figure 1. XLU/ weekly

So if I were to define a "breakout" this is how I would do it: 1) price must be consolidating to a statistically significant degree and with the XLU, this is the case as the indicator is below the lower trading band; 2) the trigger to enter the trade would be a weekly close over the trend line formed by two down sloping pivot points, and with the XLU, this appears to be the case as the week comes to a close. This would be above 29.57 on XLU. A reasonable stop loss, which would indicate that this trade is a failure, would be a weekly close below the most recent pivot low point (blue up arrows) at 28.94.

The width of the base (or prior trading range) is about 6 XLU points. Therefore, a reasonable target for XLU is 36 (i.e., breakout point at 30 +6 point base= 36). This also happens to correspond with its breakdown point seen in September, 2008.