US INTEREST RATES

Dec 10-year T-note prices are consolidating moderately below their recent 5-1/2 month high while the 10-year T-note yield continues to trade moderately above its recent 5-month low yield of 3.10%. Bullish factors for T-note prices include (1) the Fed's Beige Book which reported that Fed banks observed "little or no" price pressures and that demand for bank loans was "weak or declining," (2) the comment from Dallas Fed President Fisher that China is "continuing" to buy US Treasuries and that US economic growth in 2010 will be "significantly below potential,” and (3) continued strong foreign demand for US Treasuries after the Treasury Department reported that foreign buyers increased their holdings of US Treasuries for the fourth consecutive month in Aug to an all-time high of $3.45 trillion. Bearish factors include (1) the comment by San Francisco Fed President Yellen that the ability of the Fed to tighten monetary policy at the right time  "shouldn't be in doubt," and (2) the comment by Dallas Fed President Fisher that "we are issuing copious amounts of debt and we have to be mindful of the fact that we can issue too much."

FOMC expectations—Market expectations for Fed policy were unchanged for the remainder of the year and were little changed for a tightening of monetary policy from mid-2010 and beyond. The market expects no significant chance of a Fed rate hike at the remainder of this year’s meetings. However, the market is then expecting a slow rise in the funds rate to 0.50% by July 2010, to 1.00% by Nov 2010 and to 2.00% by July 2011.

US STOCK INDEXES

Upside momentum in the stock market continued as the S&P 500 index pushed to a new 1-year high. That 1-year high represents a 48% correction of the 2-year plunge from the record high in Oct 2007 to March’s 13-yr low. Bullish factors for stocks include (1) the mostly stronger-than-expected Q3 company earnings reported thus far, (2) the Fed's Beige Book which reported "stabilization or modest improvements" in many areas of the economy with "little or no" price pressures, and (3) the prediction from Merrill Lynch that US stocks are likely to extend their gains as investors shun record low yields in fixed-income markets and make stocks the "default asset class of choice." Bearish factors include (1) the report from the US Labor Department which said unemployment rose in 23 US states last month and hit record highs in Nevada, Rhode Island and Florida, signaling scant evidence of new hiring or job growth in the US economy, (2)  valuation concerns as the recent rally has left the S&P 500 Index trading at about 20.5 times trailing earnings, the highest since 2004, and (3) concerns about consumer spending after Wal-Mart said it expects a "tough" holiday shopping season.

Earnings expectations for the S&P 500 are as follows, according to Thomson Financial: Q3-2009 (-22.6%), Q4-2009 (+200.3%), Q1-2010 (+35.8%), Q2-2010 (+19.3%). S&P 500 annual earnings are expected at -10.2% in 2009 and +28.2% in 2010 (2008 -23.9%, 2007 -3.7%, 2006 +16.1%, 2005 +13.7%, 2004 +20.2%, 2003 +18.4%, vs 25-year average of +8.6%). The S&P 500 forward P/E (based on forward-looking earnings) is at 17.7, well above the 5-year average of 15.3.

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