US INTEREST RATES

Dec 10-year T-note prices rallied to match last month’s 6-1/2 month high, while the 10-year T-note yield fell to a 5-week low of 3.31%, moderately above last month’s 6-month low of 3.10%. Bullish factors for T-note prices include (1) comments from Philadelphia Fed President Plosser who said he’s not concerned about inflation in the short run as prices aren’t “out of alignment,” (2) the smaller-than-expected gains in Oct industrial production and capacity utilization (industrial production +0.1% versus expectations of +0.4% and capacity utilization +0.2 to 70.7% versus expectations of +0.3 to 70.8%), and (3) increased foreign demand for Treasuries as foreigners bought $44.7 billion of Treasury notes and bonds in Sep compared with $28 billion purchased in Aug. Bearish factors include (1) the larger-than-expected increase in the Nov Philadelphia Fed manufacturing index which rose to its highest level in 2-1/3 years (+5.2 to 16.7 versus expectations of +0.7 to 12.2), and (2) a steepening of the yield curve after St. Louis Fed President Bullard’s comment that the Fed may not begin to raise interest rates until 2012 led to speculation that inflation expectations may increase.

FOMC expectations—Market expectations for Fed policy were unchanged for the remainder of the year and were pushed back slightly for a tightening of monetary policy for 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 Oct 2010 and to 1.00% by Feb 2011.

US STOCK INDEXES

 The S&P 500 index on Monday climbed to a 13-1/2 month high and corrected 49% of the 2-year plunge from the record high in Oct 2007 to March’s 13-year low, but then fell on Thursday. Bullish factors include (1) Citigroup's hike in its 2009 year-end estimate for the S&P 500 to 1,100 and its hike in its 2010 estimate to 1,150 which may "overshoot" and jump as high as 1,250 if investors allocate more cash to mutual funds, and (2) comments from Fed Chairman Bernanke suggesting the Fed is willing to leave interest rates at a record low for as long as needed to stimulate job growth and promote bank lending. Bearish factors include (1) concerns over the housing market and its implications on the economy after Q3 US mortgage delinquencies rose to a record, Oct US housing starts and building permits unexpectedly fell to their lowest levels in six months, and the weekly MBA purchase mortgage sub-index plunged to a 12-year low, which signals that the weak labor market and tough credit conditions may prolong the US housing crisis, and (2) valuation concerns with S&P 500 companies trading at 22 times reported earnings from continuing operations, a 7-year high.

Earnings expectations for the S&P 500 are as follows, according to Thomson Financial: Q3-2009 (-13.8%), Q4-2009 (+216.4%), Q1-2010 (+37.9%), Q2-2010 (+21.5%). S&P 500 annual earnings are expected at -7.0% in 2009 and +26.0% 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 17.3, well above the 5-year average of 15.3.

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