Market prognosticators are calling for a good year in 2005. Whether next year will be profitable will depend on the pace of U.S. economic growth along with the prospects for employment, inflation and employment costs. Corporate profits could pick up steam if employment growth allows more consumers a greater degree of discretionary income. A small amount of inflation isn't always bad for the equity market, as long as product prices can rise along with labor costs and keep profit margins in check. Some investors fear that a rising interest rate environment could be bad for the stock market. In fact, interest rates are often rising during periods of healthy economic growth that are accompanied by strong profits. This would not be bad for the stock market.

BONDS
Except for the long end, Treasury yields closed the year higher than a year ago. Yields on 5-year Treasury notes increased 36 basis points from a year ago; 3-year note yields rose 85 basis points from a year ago; and 2-year note yields jumped 125 basis points from last year at this time. The 125 basis point gain in the 2-year note matches exactly the increase in the Fed's federal funds rate target which began the year at 1 percent but ended the year 125 basis points higher at 2.25 percent. The Fed finally began to remove their policy accommodation at the end of June. Between June 30th and December 10th, the Fed raised the fed funds rate target five times in increments of 25 basis points.

It isn't unusual to see the yield curve flatten when the Fed takes a less accommodative stance. Before the Fed began to raise its target rate, bond investors began to fear that inflationary pressures might spiral out of control without a vigilant Fed. But as the Fed maintained their resolve to remove policy accommodation at a measured pace, the long end of the yield curve moderated instead of rising further. The 30-year note yield is down 25 basis points from a year ago; the 10-year note yield is down only 3 basis points from last year.

Economists are in agreement that the Fed will continue to remove policy accommodation in 2005 and the fed funds rate target will head higher. Don't worry, you can still complain that economists never see eye to eye, because they don't agree on the magnitude that the Fed will raise the funds rate target. Some economists are calling for increases of roughly 50 basis points in 2005, while others are looking for increases of greater magnitude such as 100 or 150 basis points. Basically, it will depend on the rate of inflation over the coming year.

As I write this column from our nation's gambling mecca in Las Vegas, I would be tempted to bet on the larger increases in the fed funds rate target since core inflation is likely to head just a bit higher in 2005 (even if energy prices moderate slightly from 2004 levels).

Markets at a Glance

Weekly percent change column reflects percent changes for all components except interest rates. Interest rate changes are reflected in simple differences.

The Economy

Labor market: good and bad
New jobless claims fell 5,000 in the week ended December 25 after jumping 15,000 in the previous week. Indeed, claims have been up and down nearly every week in the past three months. However, the persistent trend is down. Claims declined in October and November, and barring a big spurt in the final week of the year, they are likely to post another drop in December. Overall, the level of average monthly new claims was fairly stable through the major part of the year, but claims are certainly lower in 2004 than in 2003. Economists are looking for moderate growth in the economy in 2005 - and that will probably allow further downward drift in new jobless claims.

While jobless claims have improved, the Conference Board's help-wanted index has not improved this year. In fact, the index inched down to 36 in November which is two points lower than it was a year ago at this time. It truly is hard to believe that companies are not advertising for new workers; after all, we have seen growth in nonfarm payrolls. Our belief is that newspaper advertising is not as prominent as it once was and that employers are more likely to use the web for job postings. Also, it is easy enough for employers to find workers through word-of-mouth as friends might recommend other friends for jobs. Monster Worldwide (of Monster.com) compiles an employment index based on web postings; this index has been on the rise through November.

NAPM-Chicago moderates in December
The business barometer from the NAPM-Chicago fell back to 61.2 in December after declining a few points in November as well to 65.2. Except for inventories and supplier deliveries, the components of this survey posted declines in December. Indeed, even the prices paid index fell back to 84.4 from 89.8. Despite the declines in the components, only the employment index actually decreased below the 50 percent mark. Oddly enough, the employment index dropped significantly - from a level of 60.8 in November to 49.1 in December. This could bode poorly for December employment figures, although it may just be a regional phenomenon.

The NAPM-Chicago is considered a leading indicator for the ISM manufacturing index. The two surveys often move in the same direction. However, the Chicago survey also incorporates the non-manufacturing sector in its results. Thus, it tends to move more dramatically from month-to-month than the ISM manufacturing index. In the past couple of months, the two haven't even moved in the same direction. Thus, investors need to be cautious in utilizing the NAPM-Chicago to predict the ISM!

Housing starts slip
Sales of existing home sales rose 2.7 percent in November to a 6.94 million unit rate; sales were 13.2 percent higher than year ago levels! In the previous week, new single-family home sales posted a sharp drop. Since existing home sales make up a lion's share of the market, total home sales rose for the month. The chart below shows the three-month moving average of home sales to smooth out monthly variations. Notice the sharp upward trend in 2004. Most economists expect that home sales will moderate in 2005 as interest rates rise. In December, mortgage rates were roughly unchanged from the October and November averages.

Year ends on optimistic note
Both consumer attitude surveys revealed that consumers were more optimistic in December than in the previous few months. The Conference Board's consumer confidence index jumped to 102.3 in December; it was nearly 10 points higher than the November level. The index was about 7 points higher than a year ago at this time. In the prior week, the University of Michigan's consumer sentiment index also posted a gain for the month, rising more than 4 points to 97.1. According to a Conference Board analyst, the improvement in the consumer confidence index stems from declines in gasoline prices during the month, not significant improvement in the labor market. Declining gas prices fueled spending on other goods and services - maybe it even helped spur holiday sales.

The Bottom Line
Economic news has been mostly favorable in the past few weeks. Consumer attitudes have improved as gasoline prices have come down. While new home sales dropped off in November, total sales are still rising with gains in the resale market. Typically, existing home prices are slightly lower than new home prices. Mortgage rates have been stable lately, but are likely to head higher in 2005. The manufacturing sector remains healthy. The NAPM-Chicago slipped in December but remained at relatively high levels. Last week, durable goods orders jumped, spurred by aircraft orders. On the whole, we are ending the year on a good note, economically.

In the meantime, U.S. servicemen are fighting a "non-war" in Iraq; the death toll mounts. The devastation in southeast Asia from last Sunday's tsunami is unprecedented. The death toll mounts daily and the numbers are staggering. In the real world, the year ends - on not such a good note.

Looking Ahead: Week of Jan 3 to Jan 7

Monday
The ISM manufacturing survey increased 1 point in November to 57.8, but remained well below the 60+ levels seen through July. The two Fed manufacturing surveys from Philadelphia and New York both increased in December and this could point to a rise in the ISM index as well, even though the NAPM-Chicago slipped during the month.

ISM manufacturing index Consensus Forecast for Dec 04: 58.2
Range: 56.5 to 60

Construction spending was unchanged in October, the weakest showing after steady increases between February and September. The residential market has slowed despite historically low interest rates and this has put a damper on total construction expenditures.

Construction spending Consensus Forecast for Nov 04: 0.2 percent
Range: -0.5 to +0.9 percent

Tuesday
Motor vehicle sales fell 1.5 percent in November with domestic auto sales running at a 5.1 million unit rate and light truck sales running at a 7.8 million unit rate. The November selling pace for domestic light trucks was the slowest since June.

Light truck sales Consensus Forecast for Dec 04: 8 million unit rate
Range: 7.7 to 8.5 million unit rate

Auto sales Consensus Forecast for Dec 04: 5.2 million unit rate
Range: 5.1 to 5.2 million unit rate

Factory orders rose 0.5 percent in October after two sluggish months. November orders are likely to see a boost since durable goods orders jumped 1.6 percent during the month. While defense capital goods orders plunged, nondefense capital goods orders posted a healthy gain for the month.

Factory orders Consensus Forecast for Nov 04: 1.0 percent
Range: 0.3 to 1.3 percent

Wednesday
The business activity index from the ISM non-manufacturing survey rose to 61.3 in November from a level of 59.8 in October and was the highest level since July. It isn't unusual to see this index run at a stronger pace than its manufacturing cousin.

Business activity index Consensus Forecast for Q3 04: 61
Range: 59.9 to 64.5

Thursday
New jobless claims fell 5,000 in the week ended December 25 to 326,000 after increasing in the previous week. Jobless claims are notoriously volatile at this time of year - falling and rising just about every other week. It appears, though, that December claims will be down from the November average.

Jobless Claims Consensus Forecast for 1/1/05: 335,000 (+9,000)
Range: 330,000 to 340,000

Friday
Nonfarm payroll employment increased 112,000 in November after posting a stronger 303,000 in the previous month. On the whole, nonfarm payroll growth has been sub par in this recovery/expansion. The civilian unemployment rate edged back down to 5.4 percent in November after ticking up to 5.5 percent in October.

Nonfarm payrolls Consensus Forecast for Dec 04: 175,000
Range: 112,000 to 300,000

Unemployment rate Consensus Forecast for Dec 04: 5.4 percent
Range: 5.3 to 5.4 percent

Average hourly earnings Consensus Forecast for Dec 04: 0.3 percent
Range: 0.1 to 0.3 percent

Average workweek Consensus Forecast for Dec 04: 33.8 hours
Range: 33.8 to 33.8 hours

Consumer installment credit increased by $7.7 billion in October after expanding $13.6 billion in the previous month. Monthly changes have fluctuated sharply recently, mostly due to ups and downs in motor vehicle sales.