The sector in the cross hairs of the bond sell-off looks poised for a bounce, says Mike Khouw

An interesting tug of war is happening in one of the market's hottest sectors: utilities.

On hand, you have the historic AI buildout fueling an unprecedented earning boom in an otherwise stogy sector. On the other hand, you have fastest rise in Treasury yields since 1994 dimming the sector's otherwise bright shine and sending the sector lower. Leaders at major tech firms continue to emphasize massive energy needs, but any signs of rising interest rates or tighter credit conditions have hit capital-intensive utility stocks first.

Utilities' dividends are also attractive to income-focused investors, and rising rates presents competition for them as bond yields become more attractive relative to dividend paying stocks.

The Utilities Select Sector ETF (XLU) was already down sharply from its recent highs when the yield curve surged.

Utilities ETF, YTD

The problem with that selloff is that nothing has slowed long-term structural demand for power. As for the bond market, any sign the conflict in Iran may come to a end could push oil prices and yields lower. This morning's weaker than expected jobs report is already weighing on rates. Still, the key backdrop that has propelled utilities—unprecedented AI-driven power demand—remains fully intact, making this sharp pullback an attractive opportunity for a defined-risk bullish trade.

Timing & Outlook

• XLU has given back all its Q1 outperformance, pulling back sharply as rising interest rates weighed heavily on rate-sensitive sectors.
• The biggest drag on the index was independent power producers (like Constellation, NRG, and Vistra), whose earnings multiples have compressed anywhere from 2 to 8 turns from their recent peaks.
• Implied volatility across the utility sector is generally low, making option spreads an efficient way to lower premium outlay while positioning for a rebound.
• Potential resistance sits at the peak levels from just 3 weeks ago. The 50-day moving average aligns directly with our upside target for a recovery within the next seven to eight weeks.

Fundamentals

• XLU trades right on or around its 10-year average P/E multiple of 17.8x. While yield spreads relative to Treasuries have turned negative and heavy capex requirements are expected to slow short-term dividend growth, the underlying valuation now offers a far better entry point than earlier this year.
• Earnings growth across the sector could see meaningful upward revisions as incremental data-center contracts are signed, and tightening power-market fundamentals drive upside to consensus estimates. A fair valuation for a sector tied directly to the AI infrastructure expansion looks reasonable, especially with leading power producers trading at significantly compressed multiples.

Bullish Thesis

• AI-driven power demand is a multi-year secular tailwind. Despite short-term rate headwinds, tech giants are actively securing long-term power purchase agreements (PPAs) to support next-generation data centers, tightening overall power-market fundamentals.
• The selloff was about rates and multiple compression, not earnings power. Shares of independent power producers (CEG, NRG, VST) saw multiples contract 2 to 8 turns during the rate surge, even as power contract pricing and long-term volume demand remained robust.
• Incremental catalysts are on the horizon. Wall Street's current estimates underappreciate potential upside from upcoming data-center power deals and accelerating grid reliability needs, giving earnings estimates clear room to move higher.

Options Trade

Given the sharp pullback to a historically average valuation, low implied volatility across the utility group, and the strong structural AI power thesis, we're looking at a bull call spread to bet on a rebound toward recent highs while keeping the net premium outlay low.

The Trade: Buy the XLU November 40/43 Call Vertical for an $0.85 net debit

• Buy the November 40 calls pay $1.15 debit
• Sell the November 43 calls at $0.30 credit.

Disclosures: Tidal owns/holds all the securities mentioned in the article.

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