Hello again, Sleuths,

When I first wrote to you about the weakness I saw in the Dow Jones Utilities Average, the index was testing its 200-day moving average.  Since that time, the Dow Utilities has risen and fallen.  As I write this column, the index is once again challenging its key 200-day long-term support line.  The ups and downs of the last month have resulted in this averaging trace out the right shoulder of a head and shoulders chart pattern.  The neckline of the head and shoulders pattern is roughly in the area of the 200-day moving average.

Sleuthers, this sector is weak!  It might bounce again.  But I’m telling you, a good stiff market wind is likely to shut the power off on this corner of the equities world.

My last Technical Tuesday column two weeks ago was a perfect time to take a position on the short-side in utilities.  However, given the way the average has traded, there looks to be more downside ahead for this sector.  So, if you don’t know how to attempt to profit from the potential weakness in this sector, let me give you some different trading or investment approaches to consider.

First, you can simply buy a put option contract on the index itself.  That’s the purest play.  But if you aren’t an options player — or if you don’t find these options that attractive (they’re not that liquid) — there are a number of other avenues you could consider.

One approach is to short one or more of the stocks of the companies that comprise the Dow Utilities.  As I mentioned in my February 28 article on this sector, there are fifteen companies in the Dow Jones Utility Average.  Those companies are:

American Electric Power Co. (AEP:NYSE)
AES Corp. (AES:NYSE)
CenterPoint Energy (CNP:NYSE)
Dominion Resources (D:NYSE)
Duke Energy (DUK:NYSE)
Consolidated Edison (ED:NYSE)
Edison International (EIX:NYSE)
Exelon Corp. (EXC:NYSE)
FirstEnergy Corp. (FE:NYSE)
NiSource Inc. (NI:NYSE)
PG&E Corp. (PCG:NYSE)
Public Service Enterprise Group Inc. (PEG:NYSE)
Southern Company (SO:NYSE)
TXU Corp. (TXU:NYSE)
Williams Companies Inc. (WMB:NYSE)

If shorting is not your game — or if you would like the leverage or clearly limited risk offered by the options market — you could buy puts on one or more of these stocks.  All of them offer options.  In the interest of full disclosure, I should mention that I suggested in the March 7 issue of MST Trader that subscribers add CenterPoint Energy to their short-side Watch List for a possible put play.

If you are seeking more of a play on the entire utilities industry — where you can take a position in a single instrument that closely replicates the performance of the sector — there are a number of other possibilities you can choose from.  All of the underlying securities I am going to mention are traded on the American Stock Exchange.

One of these securities is what’s known as a HOLDRS — which stands for Holding Company Depository Receipts.  These Depository Receipts are designed to replicate the performance of specific companies within a particular industry, sector, or group in one security.  According to the American Stock Exchange’s website –- http://www.amex.com – there are currently seventeen different HOLDRS traded.  These HOLDRS are liquid and are actively traded. 

One of these securities is the Utilities HOLDRS (UTH:AMEX).  The UTH consists of the stocks of the following nineteen companies — most of which you will notice are also part of the Dow Jones Utility Average:

American Electric Power Co. (AEP:NYSE)
CenterPoint Energy (CNP:NYSE)
Consolidated Edison (ED:NYSE)
Dominion Resources (D:NYSE)
Duke Energy (DUK:NYSE)
Dynegy, Inc. (DYN:NYSE)
Edison International (EIX:NYSE)
El Paso Corp. (EP:NYSE)
Entergy Corp. (ETR:NYSE)
Exelon Corp. (EXC:NYSE)
FirstEnergy Corp. (FE:NYSE)
FPL Group, Inc. (FPL:NYSE)
PG&E Corp. (PCG:NYSE)
Progress Energy Inc. (PGN:NYSE)
Public Service Enterprise Group Inc. (PEG:NYSE)
Reliant Energy Inc. (RRI:NYSE)
Southern Company (SO:NYSE)
TXU Corp. (TXU:NYSE)
Williams Companies Inc. (WMB:NYSE)

You have several different alternatives here.  One possibility is to simply take a short position in the Utilities HOLDRS itself.  What’s nice about shorting the UTH is that — unlike stocks that trade on the New York Stock Exchange — it is not necessary to wait for an uptick in the price of the security for your open short order to be executed.  Alternatively, you can pinpoint one or more of the nineteen stocks in the UTH you think to be particularly weak and establish your short
position(s).

Again, if you are not comfortable with the concept of shorting — or the theoretical unlimited risk inherent in this method of trading and investing — you can purchase a put option.  You can either purchase a put on the UTF itself or on any of the individual UTH components listed above. 

In case I haven’t described enough alternatives for you, there is yet another way to bet on the downside in utilities.  There are a few other utilities-specific investment vehicles known as Exchange Traded Funds (ETFs as they is commonly referred to).   Unlike the Utilities HOLDRS — which is composed of a fixed list of stocks — the companies contained in an ETF change over time.  Thus, these securities are is more analogous to a mutual fund than a market index. 

However, Exchange Traded Funds share two important characteristics with the HOLDRS.  First, all of the ETFs related to the utilities sector may be shorted without an uptick.  Second, all these ETFs have options. 

There are several Exchange Traded Funds traded on the American Stock Exchange that are specifically tailored to the performance of the utilities sector.  One series of ETFs is known as iShares.  Thirteen of these iShares that trade on the American Stock Exchange were created by Dow Jones & Company to represent the performance of different market sectors.  One of these iShares is the Dow Jones U.S. Utilities Sector Index Fund (IDU:AMEX). 

What is interesting about the IDU is that its results are intended to correlate generally with the Dow Jones Utilities Average.  So, if your intent is to find a security that most closely tracks the performance of the Dow Utilities, the IDU is probably your ticket.

Another popular ETF created to track utilities industry stocks is the Utilities Select Sector SPDR (XLU:AMEX).  The Utilities Select Sector SPDR is one of nine different Select Sector SPDR Funds that trade on the American Stock Exchange.  These funds consist of a portfolio of stocks designed to reflect the performance of a particular sector’s companies within the S&P 500 Index.

There are two other Exchange Traded Funds trading on the American Stock Exchange intended to reflect the general performance of stocks in the utilities industry — the PowerShares Dynamic Portfolio (PUI:AMEX) and the Vanguard Utilities VIPERs (VPU:AMEX).  Both of these Exchange Traded Funds have options.  However, both of these securities have much lighter volume than the ETFs or the HOLDRS mentioned above.  And the options on both of these ETFs lack the liquidity of the alternatives described earlier.  So, you would be better off sticking with other, more actively traded investment vehicles.

There may be other ways you can play the vulnerability inherent in the utilities sector.  However, I have listed a host of possible choices from which you can design a successful short-side strategy.  Just decide upon the method with which you are most comfortable, pick a good entry point, choose you risk threshold, and select a profit target.  Then, go after it — before they shut the power on these utilities stocks.

Trade well,

Mark Bail
March 14, 2006

Penny Sleuth Contributor

The Penny Sleuth also features commentary by other financial analysts, small-cap experts, investment gurus and an array of contributors from various fields and occupations. Their diverse insights and contrarian investing ideas are hand selected by the Penny Sleuth editors.

View articles by Penny Sleuth Contributor