An interesting tug of war is occurring in one of the hottest sectors of the market: utilities.
Meanwhile, historic AI builds are delivering an unprecedented revenue boom in a stagnant sector. Meanwhile, Treasury yields are rising at the fastest rate since 1994, the sector’s bright spots have faded, and sector stocks have fallen. While leaders of big tech companies continue to emphasize massive energy demand, rising interest rates and signs of tightening credit conditions are hitting capital-intensive utility stocks first.
Utility dividends are also attractive to income-focused investors, and rising interest rates will create competition for utilities as bond yields become more attractive compared to high-dividend stocks.
Utilities Select Sector ETF (XLU) By the time the yield curve spiked, it had already fallen significantly from recent highs.
Utilities ETFs, year-to-date
The problem with this decline is that there is nothing to slow long-term structural demand for electricity. As for the bond market, oil prices and yields could fall if there are signs of an end to the Iran conflict. A weaker-than-expected jobs report released this morning is already weighing on interest rates. Still, the key context driving the utility remains fully intact, namely unprecedented AI-driven power demand, making this sharp decline an attractive opportunity for bullish trades with clear risks.
timing and outlook
XLU regained all of its first-quarter outperformance and fell sharply as rising interest rates weighed on rate-sensitive sectors. The biggest drags on the index have been independent power producers (constellation, NRG, Vistra, etc.), whose earnings multiples have compressed two to eight turns from recent peaks. Implied volatility across the utilities sector is generally low, making option spreads an effective way to lower premium expenses while positioning yourself for a rebound. Potential resistance lines exist. It is at its peak level just three weeks ago. The 50-day moving average is directly aligned with our upside objective of a recovery within the next 7-8 weeks.
basic
XLU is trading at about the same as its 10-year average P/E multiple of 17.8x. While yield spreads over U.S. Treasuries have turned negative and heavy capital spending is expected to slow short-term dividend growth, underlying valuations are a much better entry point than they were earlier this year. Incremental data center contract signings and tightening power market fundamentals could result in a significant upward revision to sector-wide earnings growth. A fair valuation of sectors directly related to AI infrastructure expansion appears reasonable, especially when major utilities are trading at heavily compressed multiples.
bullish theory
AI-driven power demand is a long-term tailwind for several years. Despite short-term interest rate headwinds, tech giants are aggressively securing long-term power purchase agreements (PPAs) to support next-generation data centers, and overall power market fundamentals are tightening. The decline was about interest rates and multiple compressions, not profitability. Shares of independent power producers (CEG, NRG, VST) saw their multiples contract between 2 and 8 times during the price spike, even though power contract pricing and long-term demand remained strong. A progressive catalyst is on the horizon. Wall Street’s current estimates underestimate the potential upside from future data center power trading and accelerating grid reliability needs, and there is clearly room for an increase in earnings estimates.
options trading
Given the sharp pullback to historically average valuations, low implied volatility across utility groups, and strong structural AI power theory, we are looking to bull call spreads to bet on a rebound to recent highs while keeping net premium expenses low.
Trade: Buy XLU November 40/43 Call Vertical for $0.85 Net Debit
If you buy the November 40th call, you will receive a $1.15 debit. The November 43 call will be paid a $0.30 credit.
Disclosure: Tidal owns/holds all securities mentioned in the article.
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