Wells Fargo Advisors' Stuart Freeman On 2014: 2.4% Growth, Profits Up 5%-6%

by: Harlan Levy

Stuart T. Freeman is managing director and chief equity strategist for Wells Fargo Advisors and held the same position with A.G. Edwards & Sons Inc.

Harlan Levy: The latest report shows the economy grew 3.2 percent in the fourth quarter, and consumer spending has risen nicely. Can the U.S. economy keep up the pace this year?

Stuart Freeman: We think the economy will grow at a faster pace than last year, when we had an average Gross Domestic Product number of 2 percent. We think we're going to see 2.4 percent this year.

In the non-emerging part of the world the economies are growing. China is growing, not at last year's pace, but we're still seeing growth, and we see growth in Japan, Europe and the U.S.

Also we don't have the fiscal drag we had earlier last year, and even though 2.4 percent is not a dramatic pace, we're seeing the growth spreading out to other parts of the economy. More individuals and companies seeing more growth is one reason consumer confidence and consumer spending are ticking along.

Even if the economy grows at only a 2.4 percent rate, we are so far into this recovery that its tentacles have gotten down into more segments of the economy.

HL: Perhaps the most important items last week were the Federal Reserve's comments on the economy and its knocking off another $10 billion - to $65 billion, down from $85 billion last year - from its monthly purchases of Treasuries and mortgage-backed securities. What's your reaction?

SF: We weren't surprised that they did taper in January. They're probably not going to try to be too cagey with this, unless they see a real reason to halt the taper. I think we'll probably see a further $10 billion taper every month, and it could well be over by the end of the year.

What you have to remember is that they put a great degree of liquidity in the economy with their monthly purchases for many years. The amount of liquidity that they put in last year will have a lingering effect. It will have a favorable impact for another nine or 10 months. They're still putting a significant amount in, so that liquidity is favorable.

Their thought is that if they slow it down, the economy will pick up the slack. If they felt that wasn't the case they would stop tapering for a while. Their thinking is in line with what the markets think, and every time they taper another month it gives somewhat of a green light to the economy, that it can take it.

I will say the tapering is one of the reasons we thought we'd see more volatility in 2014 than in 2013, and that's because we had such a low-volatility market last year. For a couple of years we did not have 10 percent pullbacks, and if liquidity slows we'll still have an economy moving forward, but the markets will behave more normally with more volatility than last year

HL: Last week's volatility in the stock markets sparked fears of a 10 percent correction. Do you expect one?

SF: We still think this is a correction which is a viable correction. First of all, the valuations aren't really extreme here on a multiple basis, and last year was the first full year when the net flows into equities were positive. It's been a long time since that happened. In other words, you saw some happiness at the end of the year, but you didn't see euphoria, nobody tripping over themselves rushing into equities. There wasn't a frenzy, and the fundamentals still look good for this year.

We're looking for earnings to be up 5 to 6 percent this year, and there's more likelihood of an upside to that number than a downside.

That's favorable. And inflation is under control, something that frequently halts a recovery. We're still seeing job growth, and we think that's going to continue domestically through the year.

What the leading indicators suggest is that this year will also be a better year GDP-wise than last year. And if you look back at the historic performance of the leading indicators versus the market and the relationship between the indicators, the economy, and the market, you'd expect a larger growth rate for the economy and for the market to hit new highs again this year.

Our target for the year-end for the S&P 500 is 1,850 to 1,900. Should earnings come in better that target would be higher.

If you look at the breadth of the market, at leading indicators, and the trend for unemployment claims and the industrial economy, there's breadth in the message that we're still in this recovery going forward.

HL: What stocks look strong and which ones look weak?

SF: We still think we're in a cyclical recovery. Although we've had this modest correction in the market so far, obviously the defensive stocks have held up well. Utilities, healthcare, those sectors have held up well as the market pulls back, which is what you expect in a cyclical recovery. With investors who get nervous and who have gains, you tend to see the cyclicals sell off because they're voting on the economy with their feet.

But For the majority of the year point to point, we think it will be a cyclical year for the sectors in the S&P 500. So we're overweight industrials and the technology sector, and we still think there's some upside coming out of this correction in the consumer discretionary area. Those are what we think will be in a better trend through the year.

We're underweight utilities and healthcare. Last year there was a mood to buy defensives and dividend-paying stocks in the first quarter, so investors tiptoed into the market from 2012, and as we moved through the year, they became more confident in the growth of the economy, so the trend for the year was in cyclical stocks last year.

So far we've got January giving us a bit of a correction and volatility as far as sectors go, but we don't think that's a trend for 2014.

HL: What do the weak data on new and pending home sales say about housing?

SF: That's' going to slow a little bit with interest rates not being on the floor and up a bit, but also December wasn't the best month for weather, and January hasn't been either. Both had an impact in recent months.

We'll continue to see housing move forward, with building permits, a leading indicator of the economy, moving forward.

We have had a softer period, but we think the housing portion of the economy will continue to move forward as we see the breadth of the economy increase and consumer confidence rising as a result. Growth in the housing segment is not over.

HL: Initial jobless claims rose in the latest report, but does that make the jobs picture gloomier?

SF: The trend in claims is down from the number of claims over the past six months, a leading indicator for jobs, which suggests a continuation of job growth this year.

HL: Does manufacturing look positive?

SF: Looking at leading indicators for non-defense durable goods and other indicators of industrial production like capital goods, we think it will be a better year for industrial production. That's why we saw a positive move in industrial stocks last year. We think industrial stocks are still a good place to be accumulating on any pullbacks and that capital spending will kick in this year to a greater degree.

Industrials tend to do better in the last half of the cycle, and, as you move ahead, companies' capacity utilization rises, and as the economy moves forward companies pick up on the capital spending. That's where we are in the cycle this year. That's one of the reasons we went overweight on industrials in 2013.

HL: What about Europe's declining inflation rate? Is deflation a worry?

SF: First of all I think the world economy will keep growth moving, but we've seen that in Europe they've been willing to drop rates, and I wouldn't be surprised if at some point rates are cut another time.

In general, we think inflation will run about 2 percent in the U.S., and the dollar will chop higher, which is one of the reasons inflation here will be under control. That's good for the economy and earnings and Price-to-Earnings multiples, having a moderate inflation rate.

I don't think deflation is dangerous. If the Fed sees that inflation is not running at an optimal pace, it's possible they would slow the taper. But I don't think right now we're looking at dramatic pressures for inflation, and with the domestic growth we see, growth in Europe, in Japan, and in China, we'll still see inflation.

We've come to a sweet spot right now with inflation. That's why we think rates, like the 10-year Treasury will move higher but not beyond 3.5 percent. It's good that rates don't back up dramatically like in 1993 and 1994, when rates rose dramatically.

We're also a ways before the Fed raises the Fed funds rate, which could happen in late 2015 or even 2016.

Disclosure: I wrote this article myself with no input from anyone else, and I have no interest, connection, or investment in any stock mentioned in the article.