Goldman Sachs: After the sharp rise, utilities remain a "dual-use option" for US stocks

The public utility sector has performed well this year, with the related sector ETF (Utilities Select Sector SPDR Fund, XLU) rising by more than 10% year-to-date.

Goldman Sachs recently released a research report stating that although the public utility sector has experienced a significant increase, its valuation is still not high, making it a "dual offensive and defensive choice". Goldman Sachs stated that the current P/E premium of public utility stocks is only 6%, which roughly matches the historical average compared to the equally weighted S&P 500 index.

Furthermore, if the rise in AI-related electricity demand is included in the long-term growth expectations, the P/E ratio and PEG ratio of the public utility sector are only at 24% of historical levels for this sector. From a macro perspective, with U.S. stock pricing based on a 3.5% real GDP growth rate, public utility stocks also provide defensive exposure. Goldman Sachs expects the sector's EPS for 2026 to be higher than market consensus, indicating further room for growth.

Still relatively cheap after the surge

Goldman Sachs stated in the report that in the past three months, the utility sector has seen a return of 16%, second only to the surges in 2003 and 2020, making it the best-performing sector in the S&P 500 index. The utility sector outperformed the equally weighted S&P 500 index by 14 percentage points.

The report suggests that most of the three-month return in the utility sector can be attributed to valuation expansion rather than recent earnings expectations improvement. 87% of the three-month increase is due to the sector's P/E ratio increasing from 15 times to 17 times. In comparison, the future 12-month earnings contribute more to the market-cap weighted S&P 500 index return.

Although historically the utility sector's valuation is relatively high, it ranks only at the 63rd percentile compared to the equally weighted S&P 500 index since 1995. The sector's P/E ratio is 17.2 times, ranking at the 79th percentile since 1995. However, the forward P/E ratio is still lower than the peak valuations of 21 times in 2020 and 2022, and is consistent with the 10-year average level. Additionally, while the U.S. stock market has experienced valuation expansion, the public utility stocks' P/E premium over the equally weighted S&P 500 index is only 6%, roughly matching the historical median (+2%) and far below the previous peak (30%+).

When calculated by the PEG ratio, the utility sector's trading price is much lower than the historical average level. The consensus "long-term" EPS growth expectation for the utility sector (usually representing the annualized growth for the next 3-5 years) has increased to 8%, and higher growth expectations are usually associated with higher valuations. When adjusting for the improvement in long-term EPS growth, the utility sector's PEG ratio is 2 times, significantly lower than the historical average of 3 times

The surge in AI-driven electricity demand will drive up utility stocks

Goldman Sachs research report believes that the cross-era electricity demand related to data centers and artificial intelligence supports the improvement of the long-term growth prospects of utility stocks.

Driven by the combined forces of AI demand, non-AI demand, and a slowdown in energy efficiency growth, Goldman Sachs expects US electricity demand to grow by 2.4% from 2022 to 2030, compared to 0% over the past decade. This increase in electricity demand is expected to lead to increased capital expenditures for utility companies, as many companies are regulated entities that must increase capital expenditures to capture incremental returns. Goldman Sachs predicts that capital expenditures for utility stocks covered by the company will increase by approximately 36% in 2024-2027 compared to 2020-2023.

Currently, the expected revenue growth in the utility sector is only slightly higher than the historical actual revenue growth of the sector. Over the past three months, the market consensus has raised the expected earnings per share (EPS) growth for utilities in 2026 by 1%. The expected EPS growth for utilities in 2026 is 8%, slightly higher than the long-term average actual EPS growth of 5%. By historical standards, this growth expectation does not seem extreme. Goldman Sachs' expectations for EPS for utility stocks in 2026 are still higher than market consensus, indicating that consensus expectations may continue to be revised upwards.

However, Goldman Sachs also points out that there is significant differentiation in returns within the utility sector, with investors mainly focusing on stocks that may benefit from short-term electricity demand growth. Data shows that the three-month return differentiation within the utility sector has sharply increased to its highest level since the technology stock bubble.

Attack and Defense

Furthermore, Goldman Sachs believes that from a macro perspective, the utility sector provides defensive functions in portfolios and should outperform the broader market during economic slowdowns.

According to the report, the performance of cyclical stocks and defensive stocks now aligns with US real economic growth of about 3.5%, which roughly matches the current economic environment as Goldman Sachs economists predict US second-quarter GDP growth of 3.2%, while the Atlanta Fed's GDPNow estimate is 3.5%.

However, Goldman Sachs economists expect US real GDP growth to gradually slow to around 2% over the next few quarters. In this environment, and even in the event of more adverse negative growth shocks, defensive stocks such as utilities will become more attractive.

However, Goldman Sachs points out that rising interest rates pose a risk to utility stocks. Utility sectors, as substitutes for bonds, typically perform poorly when bond yields rise. Although the correlation between utility excess returns and changes in the nominal yield of 10-year US Treasuries has become less negative, it is still negative. While Fed Chair Powell currently opposes rate hikes, Goldman Sachs' baseline forecast by rate strategists does not imply higher yields. However, if we return to an environment of rising bond yields, it could suppress the performance of the utility sector Goldman Sachs stated in a research report that both mutual funds and hedge funds have increased their exposure to the public utility sector to the highest level in a decade. Hedge funds increased their exposure to the public utility sector by 151 basis points in the first quarter of 2024, the highest among all sectors, shifting from underweight by 76 basis points to overweight by 75 basis points. Core, growth, and value mutual fund managers all increased their exposure to the public utility sector in the first quarter of 2024. However, large-cap managers still underweighted the sector by an average of 27 basis points