by Russ Koes­terich, Chief Invest­ment Strate­gist, iShares

Call #1: Under­weight US util­i­ties sector

The US util­i­ties sec­tor was a top per­former in 2011, gain­ing roughly 15% com­pared with a flat per­for­mance for the broader market.

In ret­ro­spect, it’s not hard to see why. Util­i­ties have two char­ac­ter­is­tics that were in demand last year: Safety and yield. How­ever, last year’s rally has now left the sec­tor very expen­sive com­pared with its his­tory and the broader market.

As of the end of Decem­ber, US util­i­ties were trad­ing at more than 13x trail­ing earn­ings, a 7% pre­mium to the broader mar­ket. Because the util­ity busi­ness is a reg­u­lated, slow growth indus­try, util­ity stocks have his­tor­i­cally traded at a 25% dis­count to the broader mar­ket. Even in the past four years, when investors have gen­er­ally favored util­i­ties as a safe-haven play, the sec­tor has still traded at about a 15% dis­count to the over­all stock market.

It’s cer­tainly true that util­ity stocks tend to do bet­ter in a rel­a­tive sense when the econ­omy is weak. But given the recent sta­bi­liza­tion in the US econ­omy, the cur­rent pre­mium looks very hard to jus­tify. Even when I account for rel­a­tively weak eco­nomic expan­sion, util­ity stocks still look around 20% over­val­ued rel­a­tive to the broader US market.

In addi­tion, if the cur­rent pref­er­en­tial tax treat­ment of div­i­dends expires as expected in 2013, mul­ti­ples may com­press in the sec­tor. As such, I’m now advo­cat­ing under­weight­ing US util­ity stocks within an equity portfolio.

For those investors still focused on income, I’d instead sug­gest focus­ing on a broad yield play such as the iShares High Div­i­dend Equity Fund (HDV) and on global tele­coms, which can be accessed through the iShares S&P Global Telecom­mu­ni­ca­tions Sec­tor Index Fund (IXP).

For those investors who are also look­ing for the rel­a­tive safety of util­ity stocks, I’m still main­tain­ing my neu­tral (or bench­mark) view of the global util­i­ties sec­tor in gen­eral, and I’m now advo­cat­ing get­ting that expo­sure through a posi­tion in inter­na­tional utilities.

Call #2: Neu­tral India

I first advo­cated an under­weight to Indian equi­ties last April. At that time, the Indian stock mar­ket looked expen­sive rel­a­tive to other devel­oped mar­kets, and I expected the Indian econ­omy to con­tend with high infla­tion through­out most of 2011.

Since then, Indian stocks have fallen approx­i­mately 30% and are trail­ing a broader emerg­ing mar­kets index by 10%. Now, Indian stocks appear more rea­son­ably priced. Large-cap Indian equi­ties are trad­ing at 12x next year’s earn­ings and at around 2x book value.

In addi­tion, while infla­tion has remained stub­bornly high in India, I expect some of that pres­sure to ease this year. In par­tic­u­lar, I expect to see an eas­ing of food infla­tion, which makes up roughly 50% of the Indian infla­tion index. This should ben­e­fit Indian equity val­u­a­tions.

For these rea­sons, I’m upgrad­ing my view of India to neu­tral. I’m advo­cat­ing an allo­ca­tion to Indian stocks equiv­a­lent to their weight in the broader MSCI emerg­ing mar­kets index. A poten­tial iShares solu­tion is the iShares S&P India Nifty 50 Index Fund (INDY).

Source: Bloomberg

Dis­clo­sure: Author is long IXP

In addi­tion to the nor­mal risks asso­ci­ated with invest­ing, inter­na­tional invest­ments may involve risk of cap­i­tal loss from unfa­vor­able fluc­tu­a­tion in cur­rency val­ues, from dif­fer­ences in gen­er­ally accepted account­ing prin­ci­ples or from eco­nomic or polit­i­cal insta­bil­ity in other nations. Emerg­ing mar­kets involve height­ened risks related to the same fac­tors as well as increased volatil­ity and lower trad­ing vol­ume. Secu­ri­ties focus­ing on a sin­gle coun­try and nar­rowly focused invest­ments may be sub­ject to higher volatil­ity.  There is no guar­an­tee that div­i­dends will be paid.  Past per­for­mance does not guar­an­tee future results.

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