Are Water Utilities Finally Ready to Rise With the Economic Tide?

Since March 9th of last year, the Standard & Poor's Composite 1500 index, a broad-based, capitalization-weighted benchmark of 1,500 U.S. companies, has rallied 75%. As it happens, all but one industry group in the index, which is comprised of the S&P 500, the S&P 400 (mid cap), and the S&P 600 (small cap), has seen a double-digit percentage rally over the span.

Can you guess which sector hasn't?

If you answered "water utilities," you would be correct. While groups such as catalog retailers, automobile manufacturers, paper products makers, broadcasters and cable operators have scored eye-popping gains of 350% or more, the sub-index that includes American States Water Company (AWR) and Aqua America Inc. (WTR) has only managed to eek out a rise of 1.3%.

Among the reasons cited for the group's dismal performance: the poor state of the economy, persistent regulatory concerns, a widespread interest in traditionally more volatile stocks and sectors and unusual weather in some parts of the country. That said, recent price action suggests the time may have come for the stock market's worst-performing sector to start playing a bit of catch-up.

To begin with, the absolute price trend (marked in blue, below) in the subsector has formed what appears to be a textbook "head and shoulders bottom," a pattern of three troughs which is frequently the hallmark of a stock or sector that is seeing increased trading volume and is ready to rise. The price has also turned up, breaking a larger pattern of decline extending from the summer of 2007.

At the same time, the relative price -- which compares the price of the water utilities sector to the whole S&P Composite 1500 -- seems to be tracing out a bullish double-bottom, a W-shaped pattern that can indicate the start of an uptick after a prolonged downward trend. Many technical analysts view it as favorable when both the relative price chart and the traditional price chart suggest the same message.

But technicals don't tell the whole story. The sector also looks like a good deal from a valuation standpoint. It's currently trading at a trailing price-earnings ratio, in which current stock prices are divided by the last year of earnings, of 22. That's not far from the lows seen back in November and in early-2003, before a strong rally for the group. Moreover, water utilities have delivered larger dividends than the broader index. The sector yielded 3.2%, which is 1.4 percentage points above that of the composite index and the widest differential since the beginning of the decade.

A stepped-up focus on the issue of shortages may also prove to be a positive catalyst for the group. Tuesday was World Water Day, for example, with one organization unveiling an "initiative to focus long-overdue attention on the emerging freshwater crisis within the United States." On Thursday, a United Nations-sponsored forum on water kicks off in Chad.

No investment is without risk, of course. In the case of the water utilities sector, it's worth bearing in mind that the S&P composite 1500 includes only two water utility companies, and the sub-index is not really tradeable on a standalone basis. A water-related exchange-traded fund, the Claymore S&P Global Water ETF (CGW), exists, but it is international in scope and includes some holdings that aren't water utilities.

Moreover, the industry has traditionally been heavily regulated and, as such, it's subject to uncertainties and constraints that many businesses don't have to contend with.

Still, for those who are looking for bargains in a market that seems quite overstretched, this sector may be one worth thinking about.

Full disclosure: no positions in any securities mentioned.