The S&P 500 (SNPINDEX:^GSPC) jumped more than 32% in 2013, including dividends. But just because the overall index rose doesn't mean that every stock within the index did as well. In fact, several entire sectors of the S&P 500 fell well behind the index's overall gains, although all of them managed to avoid outright losses. Let's look at the worst S&P sectors last year to find out why investors in utility and telecom stocks dramatically underperformed the S&P 500's results in 2013.
When you look at the returns of both of these sectors in 2013, you'll find eerily similar numbers. Utility stocks in the S&P 500 rose 13% this year, while telecom stocks gained just 11% in 2013. Yet even though these industries have a lot of differences, the same general concerns weighed on both of their respective results this year, and they largely boil down to one overarching event: the Federal Reserve's decision to start pulling back on its bond-buying activity through its quantitative easing policy.
In particular, you can see that problems began for many utility and telecom stocks in May and June and persisted in many cases throughout the year. Utilities Exelon (NYSE:EXC) and Southern (NYSE:SO) struggled to avoid big losses for the year, while telecom giants AT&T (NYSE:T) and Verizon (NYSE:VZ) did a better job of producing at least modest gains for the year. The May/June period was when the Fed started discussing the possibility of reducing its QE activity, and even though it took until the end of the year for the Fed to actually pull the trigger on a policy shift, the fear was enough to send long-term interest rates much higher.
Higher interest rates are of particular concern for utilities and telecoms because of the massive amounts of capital investment necessary for their respective operations. Building wireless networks and utility grids is enormously expensive, and most companies in the two sectors keep large debt loads compared to stocks in other sectors. As a result, they're more sensitive to changes in interest rates than other companies.
One thing to note, though, is that the low rate environment in 2012 and early 2013 gave these companies a chance to lock in extremely cheap financing. For instance, as part of its deal to take over complete control of its Verizon Wireless division, Verizon issued the biggest bond offering ever, with much of the debt representing long-term borrowing with maturities well in the future. Similarly, AT&T, Exelon, and Southern have all had the opportunity to restructure their debt to take maximum advantage of low rates, and it'll take a while before rising rates will have their full impact on earnings.
Eventually, though, existing low-rate debt will come due, and if rates have risen by that time, utilities and telecoms will have to pay more in interest payments, cutting earnings. Even though their usually attractive dividends might look even more enticing if prices fall, the higher rates available from bonds and other income-producing alternatives could make shareholders less willing to take the risk of owning utility and telecom stocks.
Of course, just because telecom and utility stocks did poorly in 2013 doesn't automatically guarantee bad performance in 2014. Yet if interest rates continue to see upward pressure this year, it could once again weigh on these interest-sensitive sectors more than on the overall market, making them potential underperformers for the foreseeable future until interest rate policy reaches more normal levels.
Find the best stocks you can
Don't settle for questionable stocks in your portfolio. Instead, pick a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.
Fool contributor Dan Caplinger has no position in any stocks mentioned. The Motley Fool recommends Exelon and Southern. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.