Utilities sector is where the 'AI craze' gets 'out of hand'

On Monday's edition of Good Buy or Goodbye, Interactive Brokers chief strategist Steve Sosnick breaks down two interest rate-sensitive sectors in a higher-for-longer economic backdrop.

Sosnick sees the Real Estate Select Sector (XLRE) ETF as a "good buy," explaining that it is "interest rate-sensitive on the way in and the way out. They borrow a lot of money, but they pay a high dividend typically." The ETF covers a diverse set of companies, from offices to apartments to data centers, he says, noting, "it's OK to be in a diverse sector as long as you have winners to help out the losers." He points to the boom of residential real estate as balancing out the struggling commercial side of real estate.

Conversely, Sosnick believes utilities (XLU) are "a manifestation of the AI craze that's gotten a little bit out of hand." He explains that while the sector's rate structure is pretty well fixed, the infrastructure is a much greater undertaking, with high costs and a longer time to build. "So if you're piling into utilities as an AI play, it's going to take you years for that to pay off," he explains. For those who already have utilities, he encourages investors to hold, but not buy more.

For more expert insight and the latest market action, click here to watch this full episode of Market Domination.

This post was written by Melanie Riehl

Video transcript

It's a big noise.

The universe of stocks out there.

Welcome to, goodbye or goodbye.

Our goal to help cut through that noise to navigate the best moves for your portfolio today, we're taking a look at two interest rate sensitive sectors in the era of higher, for longer.

What is the best way to play it?

I'm here with Steve.

So interactive brokers chief strategy.

Good to see you.

Thanks for being here.

Great to see you too, Julie.

So let's get to the first of these and that is real estate as a sector here being expressed by the XL re the ETF that tracks it and this is definitely an interest rate sensitive sector.

You can see it's gone kind of sideways over the past 12 months or so.

Um Talk to me about why we're investing here, the hunt for yield in both of these sectors.

You're talking about defense perpetually defensive type of sectors that are very much geared toward interest rates.

In the case of real estate.

It's it's interest rate sensitive on the way in and the way out.

They, they borrow a lot of money, but they pay a high dividend typically real estate though is, has been very heterogeneous.

There's certain parts of it that are blowing the doors off.

Those are the parts that just completely stink.

And I think that's kind of, I think the people are on the risky parts of it without necessarily noticing the more, um, you know, the, the more healthy parts of it.

Well, I wanna dig into that.

But first, as we talk about the hunt for yield, do these companies tend, does this group tend to only take off when rates actually start to cut or do they anticipate it?

They should anticipate it then?

You know, and I think part of the problem is we've gone from anticipating a lot of rate cuts to have it.

Right.

I mean, we were, we started the Earth looking at 6 to 7 rate cuts.

We got as low as like, basically, and now we're kind of back to two.

you know, so that has the, this broader stock market is kind of shrugged it off because, ok, it's a good economy, it's fine.

Real estate is kind of muddled along because they are so interest rate sensitive.

So it hasn't really helped them out.

Got you.

So let's then get to that other point we're making, which is that this is a diverse set of comp of companies.

You've got office, but you also have mall and you have apartment and you have data centers and, you know, all different kinds of real estate owners.

That's the key there.

I mean, I, I don't know that I would feel comfortable in investing in too many specific res because you really need heavy duty analysis for that.

And that's just not that, that's not my belly work.

And so I wouldn't, I wouldn't wanna propose that to anybody, but when you take a big basket of them, as we know, there's certain parts, you know, residential is going crazy on the good side, commercial is really stressed and you've got everything else in between.

So I think it's, it's ok to be in a diverse se sector.

Um, as long as you, you know, as long as you have winners to, to help out the losers.

Right.

Exactly.

And then also, um this group, as we looked at that long term chart hasn't done so hot.

No, it's been kind of lousy.

And that's why I'm thinking if you wanna be in a, in a sector that pays yield, this may be your better choice right now comparatively.

And we'll see the second part of it in a minute, but the underperformance is, it's done, it's done nothing for the better part of two years.

Yeah.

And then we always like to talk about the, what the risk could be and that's, you know, the high rates stay high and that you have more of that impact across the, that set of diverse companies.

Perhaps I will say the risks here should be relatively self evident.

Um You know, if, if the, if the good sectors stop performing well, the good sub sectors, I should say stop performing well.

Yeah, this is, this is, this is that can be trouble for everybody.

Um How stressed do they get in, in terms of the higher rates?

If people just really say, you know what I'm on a buyer strike, I can't afford to buy houses.

I can't afford to, I can't afford to move.

That does, that does have an impact and in a good way, although ironically the one sort of subsector that's not really represented in the accelerate is like single family homes to the same extent.

Right.

It's apartments are in here, but residential is sort of underrepresented.

It feels like in the accelerate it, it, by definition, it kind of has to be because really the only way to get the investment trust.

Exactly.

It's, it's my house, it's your house.

There's no way, there's no way for someone else to invest in those.

And, you know, you can get into the home builders, but that's not really, that's not really what this covers.

So it does really leave out residential sector except for multi family.

Right.

And then let's talk about the other group that we've been alluding to obliquely, the one that you would avoid and that's utilities.

And here I have to say I feel personally attacked because I wrote about utilities in the morning brief last week and how they have been benefiting.

This is a group that's up, what, more than 10% this year, which is part of the reason you say.

Yeah, maybe it's a little much.

Well, that's it.

I mean, you know, let's put it this way.

I, I'm in some ways, I'm talking my own book in a bad way.

I do futility stocks.

I, I've always had an allocation to them because I like the yield.

But I think the A I, I think this is a manifestation of the A I craze that's gotten a little bit out of hand.

There have been certain sub pockets where people, this is what happened sort of in the end phases of a, of a mania is you start to look for all the different places where people haven't looked yet.

Copper was one of them.

Oh, we need to, we need to wire the country for all this power that we, that we need.

Well, uh utilities are the ones providing it.

The problem for utilities are their, their rate structure is pretty well fixed.

That's the good side of investing in utilities.

You know, they pretty much know what their costs are going to be unless there's an energy shock.

They pretty much know what they can charge in rates and, you know, and then they pay a certain amount of that out in dividends.

The, the problem here is it takes for, I don't know how many, how long it takes to build exactly.

A new power plant depends on what kind you're gonna build.

So, if you're piling into utilities as an A I play, it's gonna take you years for that to pay off.

Doesn't mean you shouldn't consider, it's not part, it doesn't mean it shouldn't be part of the bull case for utilities in the long run.

But on the other hand, a te, a 10% 12% rise like we've had this year, it's a little much in a short period if you're waiting on capacity to built out.

Um you also see future discounting came too early.

What do you mean by that?

What I mean is it takes, you know, however many years to build the power plants and that's exactly what it comes down to it.

Yes.

Uh Let me, let's stipulate that, that A I will create demand for electricity.

Let's stipulate that it's pretty hard to imagine demand for you for electricity shrinking in, in any meaningful way o over the over the foreseeable future, they're, they're gonna be the ones providing it.

But how long when and to what cost, how much can it go up with the existing capacity?

And then finally you get nervous when boring sectors become exciting.

And this, this is exactly what I wrote about in our morning brief newsletter last week.

Is that A I had succeeded in making utility sexy, which is not easy to do.

Yeah, that's the problem.

And that, which is not to dis what you were saying.

I wrote, I wrote something about that along those lines as well is that, you know, the copper and utilities have become A I plays.

But that in that, in my mind is why this is why this is one to avoid right now.

It, it, it, it does again, if you have, it don't sell your ti don't sell them.

I'm not selling mine, but I'm not buying any more up here because of the, because they got over extended because they, the, the utility sector has more or less matched the S and P 500 year on a year to date performance basis.

Think about that and this and, and this is the kind of environment when you, when you have defensive sector, it either means you've got a sort of a retrograde economy or, or interest rates are going in your favor.

Really?

Neither has happened and yet the utility stocks went crazy and things could still get, continue to be crazy, right?

We've all seen this crazy can get crazier.

So, so that, that is the risk to the, that is the risk to the, to the, to the negative.

But as you said, you have an allocation, you just wouldn't be adding here.

So you could still benefit from that.

And let's skip to this chart um which is a three chart of these two, you've got the utilities in blue and real estate in purple.

And this just again, kind of more starkly portrays the underperformance of real estate.

Absolutely.

In this part of the chart, this was, you know, the sort of the end run of COVID of the COVID era trade when you had zero interest rates and, and the markets were going up, they both did.

Ok. Obviously, you know, there's other sectors that would be up here on the chart, but these both did, they more or less moved together.

And then we started to get into the rate hiking cycle in earnest and the utilities because they have a stable earning stream, they do, they sort of muddled along.

And then you see here at the end how they popped up.

Well, and I guess like chat GP T was right around here.

Yes.

And, but on the other hand, the real estate story got out of hand in the, toward the end of 22 and we've never really come out of those doldrums.

So that's really, and so that gap at the, at the very right hand side is where is what I'm talking about here?

Got you.

All right.

And so, and as you said, you do have an allocation utilities, but you have one in real estate as well.

I mean, thanks so much, Steve.

Good to see you as always.

And thank you so much for watching.

Goodbye or goodbye.

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