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The Stock Market is at a Crossroads

The U.S. stock market is at a crossroads. Valuations have reached long term historical averages reducing the chances of outsized gains. Meanwhile, the U.S. economy continues to add over 200,000 jobs monthly. Strong consumer confidence is indicating continued earnings growth for U.S. corporations. Amid this backdrop, the stock market has been oscillating between gains and losses.

With stocks no longer below average valuations1, earnings will need to keep growing in order for the stock market to continue its historic bull run. The good news is that the U.S. economy is adding new jobs at a healthy clip2, which will help companies grow their bottom lines.

The strength of the U.S. economy compared to rest of the world’s economies has also contributed to the strong dollar, which has appreciated against most of the world’s currencies. This has put downward earnings pressure on U.S. multinational corporations. With the EU in the midst of a large quantitative easing program, it is hard to see when the U.S. dollar will cease its climb. This makes investing in U.S. stocks tricky, as these stocks are fairly valued and therefore puts them at risk of sharp declines if earnings miss expectations.

Taking a look at the latest earnings reports, this season has been a bit of a mixed bag. U.S. dollar strength combined with slow growth in Europe has been a drag on U.S. multinational companies, leading to reduced earnings forecasts. If the U.S. dollar continues its strengthening trend , companies may miss their earnings forecasts. Considering many companies are trading near historical valuation averages, any unexpected bad news may cause these stocks to decline further.

At the same time, there are pockets in the market where valuations are very compelling. An example of this can be seen with U.S. retailers, which tend to have low foreign exposure, are leveraged to increased consumer spending, and trade at reasonable valuations. Similarly, media companies, such as Viacom (NYSE:VIAB) and Starz3 (NASDAQ: STRZA), tend to trade at valuations lower than the S&P 500, making their shares an attractive investment in our view.

However these are not the only compelling sectors to consider, as the overall market is trading at or near full valuations. A few key technology stocks are also trading at reasonable valuations. Verizon Communications (NYSE:VZ) trades at 12.5 times 2016 estimated earnings, and has a 4.5% dividend yield. Since most of their sales are in the United States, Verizon has limited currency risk which is very appealing in the current strong dollar environment. Another compelling technology stock is Facebook4 (NASDAQ:FB), which is trading at a low valuation considering the strong growth the company has in front of it. Although there are specific technology stocks we like, many of the so-called “old tech” companies such as Microsoft and Hewlett Packard have large exposure to the weakening Euro which leaves them prone to substantial declines.

There is currently of tug of war in the market between the strengthening US economy and currency headwinds leading to lower sales. It is hard to predict which force will have a greater effect, and therefore the direction of the stock market is hard to ascertain. While opportunities abound, many stocks are fully valued leaving the overall market vulnerable to a correction. In this environment, it makes sense to selectively pick individual stocks which trade at reasonable valuations.

 

Disclosure: Ideal Asset Management LLC is long shares of FB, STRZA, VIAB, BBBY, VZ for its clients.

All ideas expressed in this article are the opinions of Ideal Asset Management LLC.

Before trading on any of the information in this article, please consult you financial advisor to make sure it suits your financial goals.

All investments carry the risk of loss.

Past performance is not indicative of future results.

 

1. Valuations have increased to a near long term historical average P/E ratio of 17.62 times expected 2015 S&P earnings. [http://www.wsj.com/mdc/public/page/2_3021-peyield.html]

2. 295,000 jobs were added in February [http://www.forbes.com/sites/samanthasharf/2015/03/06/jobs-report-u-s-economy-added-295000-jobs-in-february-unemployment-down-to-5-5/]

3. Ideal Asset Management is currently invested in Viacom (NYSE:VIAB) and Starz (NASDAQ: STRZA)

4. Ideal Asset Management is currently invested in is Facebook (NASDAQ:FB)

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