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Commodity Investing Shell Shocked
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Improving economic conditions in China lifted investor confidence despite a week of mixed activity across global markets. Despite a strong showing by markets in Europe, the S&P 500 continued its slide from record-high levels this month as bulls have struggled to maintain upward momentum over the past few sessions as Fed tapering worries continue to weigh on investors. But in spite of the concern, the predominant view amongst U.S. investors is that multiple expansions will propel the market higher and that earnings growth will come from margin improvement. But at current valuation levels, this may be wishful thinking.

Profit margins on U.S. companies are currently at all-time highs and well beyond their historical average of the last sixty years. Not only are profit margins high, they have been expanding for four consecutive years and may be running out of room for future expansion. Corporate cost cutting seems to have run its course and share buybacks are beginning to loose their lustre with investors. Making matters worse, there have only been four other periods since 1950 when corporate profits were able to continue to expand beyond the four year mark, suggesting the market may have put in its high for the year.

Adding to the froth is a gold-rush mentality in initial public offerings (IPOs). With the S&P 500 up 18.5% since the beginning of the year, bankers have been telling companies that the time is ripe to take advantage of lofty markets by going public. Not only are markets higher, but investors are relatively complacent, with the CBOE Vix index trading at near multi-year lows. According to Dealogic, a total of 28 companies have raised $5.2 billion from U.S. IPOs since July, marking the fastest rate of activity since 2007.

The companies coming to market lately have been disproportionately in real estate and construction-focused businesses that have benefited from a recovery in U.S. housing and the commercial real estate market that has lifted valuations and fed investor demand. The largest deal in the quarter so far was the American Homes 4 Rent’s IPO, which raised $706 million and subsequently traded lower on interest rate uncertainty.

But despite the stock market's rapid rise, consumer spending appears to be pretty solid and could help support further market gains. During the second quarter of 2013, U.S. consumer spending clocked in at 1.8% led by autos, while core retail spending has been growing modestly. The financial obligations ratio (measures households’ debt service and rent payments relative to income) have hit a 33-year low, suggesting that consumers have the capacity to keep on spending. Consumer stocks have been on a tear, outpacing the S&P 500 this year. With a consumer recovery well entrenched, it probably isn't advisable to bet against the American consumer.

The stock market may be challenged to maintain the momentum it’s managed to generate so far this year, but with many economic forecasters calling for a healthier GDP growth rate in the second half of the year, it may be premature to call a market top. Further upside in the stock market is likely going to created by a rebound in capital expenditures (capex) in the coming years, rather than through cost cutting or share buybacks. There is tremendous pent-up investment spending demand, created by the sorry state of corporate assets. The average age of corporate software and equipment is at its highest level in fifteen years, suggesting the need for massive levels of corporate spending in the years to come, which should in turn, should benefit corporate profits and stock market performance.

With just eighteen S&P 500 companies reporting this coming week, I am expecting stocks to trade within a narrow range for the next little while. But for my money, I’m looking at these sideways markets as great opportunities to build positions in the deeply discounted financials and technology sectors before economic and corporate growth picks up again toward the end of the year.

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