STOCKS
Equities started last week with their largest drop in months on Monday. Much of the decline appeared to be profit taking but an announcement by Wal-Mart that same-store sales would edge down overshadowed favorable reports on holiday spending by consumers from other retailers. Also, a jump in crude oil prices weighed on stocks overall but notably on airlines. Technology was particularly hard hit, largely due to having seen the greatest gains recently. Stocks rebounded modestly on Tuesday despite weak economic numbers on durables orders and existing home sales. Comments by Fed Chairman Ben Bernanke appeared to help market confidence. However, equity markets continue to be more optimistic about the health of the economy than the bond markets. Some of Tuesday's rebound was merely coming off what some saw as oversold positions on Monday - notably for technology stocks. Stocks were boosted on Wednesday by a sizeable upward revision to third quarter GDP and by a moderately favorable Beige Book. Stocks were little changed on Thursday as positive numbers in the personal income report and weak new housing sales and a jump in jobless claims were seen as offsetting. Notable company stocks were mixed as some chain stores had positive results but fell short of expectations but a number of home builders were upgraded by Banc of America Securities analysts. Friday's below 50 figure in the ISM composite index and broad drop in construction outlays changed market psychology and led to a sizeable decline at week end. Friday's declines were led by some notable blue chips as well as high-techs - including Caterpillar, Corning, and Intel. Homebuilder stocks improved as market belief in pending interest rate cuts by the Fed were seen to lift that industry in coming months.

For the week, all major indexes were down: the Dow, down 0.7 percent; the S&P 500, down 0.3 percent; the Nasdaq, down 1.9 percent; and the Russell 2000, down 1.4 percent. Year-to-date, the Dow is up 13.8 percent; the S&P 500 up 11.9 percent; the Nasdaq up 9.4 percent; and the Russell 2000 up 16.0 percent.

Over the month of November, the technology sector helped boost the Nasdaq 2.7 percent. Small caps followed with the Russell 2000 up 2.5 percent. Blue chips lagged as the Dow and the S&P 500 rose 1.2 percent and 1.6 percent, respectively.

BONDS
Interest rates fell sharply last week except on the short end. Bond prices were boosted right out of the gate on Monday as the drop in the stock market and in the dollar led to some flight to quality in bonds. The bond market's generally bearish view on the economy (but bullish on bond prices) was confirmed to a large degree Tuesday with a weak durables goods report and rates continued to slip. However, the week-long slide hit a bump in the road on Wednesday as third quarter GDP was revised up from 1.6 percent to 2.2 percent. On Thursday, economic data pushed rates down significantly across the yield curve except on the short end. A jump in initial jobless claims, a drop in new home sales, and a below 50 reading for the Chicago purchasing managers index more than offset the healthy personal income report. Friday's weak reports from the ISM and from the Commerce Department on construction outlays pushed rates down even further. The ten-year Treasury note ended the week at 4.43 percent - the lowest level since late January of this year.

Net for the week the Treasury yield curve is down - and sharply so for intermediate rates. Yields fell as follows: 2-year Treasury note, down 21 basis points; 3-year, down 20 basis points; 5-year, down 16 basis points; the 10-year bond, down 12 basis points, and the 30-year bond, down 8 basis points. The 3-month Treasury bill is unchanged.

Rates fell sharply last week except on the short end, with longer maturities at levels not seen since late January 2006.

Markets at a Glance

The Economy
Last week's economic data pointed to a stronger-than-previously believed third quarter but then indicated that the current quarter is weaker than expected. Weakness that was only showing up in housing and in autos has spread into manufacturing in general and to nonresidential construction. What do the latest numbers tell us about how the soft landing is shaping up or reshaping' Indeed, there are signs of notable reshaping.

GDP surprises on the upside
The strength and mix of third quarter GDP provides the starting point for the economy moving forward. The markets initially took comfort from the upward revisions to third quarter real GDP. Growth was revised up to 2.2 percent annualized from the initial estimate of 1.6 percent. The upward revision was due to upward revisions to business fixed investment, inventory investment, and government purchases, as well as a lower revision to imports. Partly offsetting these factors were lower estimates for personal consumption, residential investment, and exports. Some pointed out that the strongest upward revision was to inventories and that overhang might be developing. But final sales to domestic purchasers remained healthy with only a slight downward revision to 2.1 percent growth in the third quarter from the initial 2.2 percent estimate.

What are the current sources of strength and weakness' Overall strength for the quarter was led by a 16.7 percent boost in nonresidential structures investment, an 6.0 percent increase in durables PCEs, a 6.3 percent rise in exports, and a 7.2 percent boost in investment in equipment & software. As expected, weakness was led by an 18.0 percent drop in residential investment and a 5.3 percent rise in imports. More recent economic data suggest that this picture may be changing. Looking forward, nonresidential investment appears to be losing momentum. However, a weaker dollar is likely to boost exports.

Where are we on the war on inflation' From the GDP report, the overall GDP price index was unrevised at 1.8 percent for the third quarter and represents a notable improvement from the 3.3 percent seen in the prior four quarters. Much of the weakness was related to lower oil prices. At the consumer level, inflation is being much more stubborn. The core deflator for PCEs - the preferred inflation measure of the Fed - was revised down to 2.2 percent from the initial estimate of 2.3 percent and followed a 2.7 percent pace in the second quarter.

Year-on-year, the GDP price index growth rate is at 2.9 percent in the third quarter from 3.3 percent in the second quarter. The core PCE deflator year-on-year growth rate stands at 2.4 percent in the third quarter, compared to 2.2 percent in the second quarter.

Personal income report shows a healthy consumer sector
For the economy to have sufficient momentum to remain on a moderately positive growth path as the more interest rate sensitive sectors weaken, the consumer sector must remain moderately healthy. Consumer spending typically makes up over two-thirds of GDP. October's personal income report boosted confidence in the consumer sector. Personal income increased 0.4 percent in October, following a 0.5 percent boost in September. Consumers, however, tend to spend more out of wages and salaries income than other types of income and this important component rose a healthy 0.6 percent in October - the same as in September.

Personal income is up 5.8 percent on a year-on-year basis, compared to 5.9 percent in September. The wages and salaries component is up 5.9 percent on a year-on-year basis - the same as in September. Barring a sharp weakening in employment, the consumer sector appears to have a sufficient income base to help the economy weather the softening in other sectors.

Indeed, consumers are doing their part to keep the economy on an upward trend - although lower gasoline prices are making it harder than usual to read the numbers on spending. Personal consumption rose 0.2 percent in October after a 0.2 percent drop in September. Once again, the overall figure for personal consumption was pulled down by declining gasoline prices as seen in nondurables. Nondurables fell 0.6 percent in October, following a 1.5 percent drop in September. For the latest month, durables rose 0.2 percent while services jumped 0.6 percent. These are all nominal numbers - current dollars. In real terms (year 2000 chained dollars), overall personal consumption posted a 0.4 percent boost in October, following a 0.2 percent gain in September.

The monthly inflation numbers from the personal income report provided a little more marginal analysis for inflation trends than the quarterly GDP report. The October personal consumption price indexes go into the quarterly GDP numbers but on a monthly basis provide a little more information on the degree of change in inflation on the margin. Once again, the impact of oil prices lead to divergent trends in overall prices versus core prices. The overall PCE deflator fell 0.2 percent in October, following a 0.3 percent drop in September. The core PCE deflator rose 0.2 percent in October - the same as in September.

On a year-on-year basis, the overall PCE deflator is up 1.5 percent in October - down from 2.0 percent in September. On a year-on-year basis, the core deflator is up 2.4 percent in October - unchanged from September. The core PCE deflator numbers remain above the Fed's target of 1 to 2 percent. However, the monthly changes are showing a very gradual downtrend in core PCE inflation.

On a year-on-year basis, the overall PCE deflator is up 1.5 percent in October - down from 2.0 percent in September. On a year-on-year basis, the core deflator is up 2.4 percent in October - unchanged from September. The core PCE deflator numbers remain above the Fed's target of 1 to 2 percent. However, the monthly changes are showing a very gradual downtrend in core PCE inflation.

Durables orders show a weakening manufacturing sector
All of the manufacturing reports last week showed weakening, starting with the report on durables orders. Durable goods orders dropped 8.3 percent in October, following a revised 8.7 percent jump in September. As expected, weakness was primarily in civilian aircraft - in the transportation component as October's orders came off the surge in Boeing orders in September. What was not expected was a decline in many other components. Excluding the volatile transportation component, new orders declined 1.7 percent, following a 0.5 percent increase in September.

But the good news is that the weakness in durables is not completely widespread. As is typical for an economy that is slowing - but not declining - durables orders were mixed with gains seen in some industries. Industry categories posting gains in October were primary metals, machinery, electrical equipment, and "other." Industry categories showing declines in October were fabricated metal products, computers & electronics, and transportation.

Year-on-year, new orders for durable goods fell to 2.3 percent from 15.2 percent in September. Unfilled durables orders slipped to a 21.8 percent year-on-year increase in October from 22.3 percent in September.

Unfilled durables orders slipped to a 21.8 percent year-on-year increase in October from 22.3 percent in September. Manufacturers are starting to dip into backlogs to keep production going. It will be important to watch how backlogs hold up or start to drop to get a better understanding of whether manufacturing is simply slowing or starting to decline.

Manufacturing surveys point to a flat manufacturing sector
First, the Chicago purchaser managers reported the first below 50 reading in 3-1/2 years with a 49.9 reading for November. A level of 50 indicates that as many respondents report declining output as those reporting increases. Essentially, the November figure indicates that manufacturing is flat (the survey does include non-manufacturing components, however). Chicago purchasers reported very modest growth in new orders but said backlogs were actually declining but at a modest rate.

At the end of last week, the ISM's national survey of manufacturers also posted a below 50 figure with 49.5 in November compared to 51.2 in October. The last time the PMI was below 50 was April 2003. As with the Chicago figure, the November ISM index essentially means that manufacturing is flat. Markets took the below 50 figure as a huge psychological negative but in reality, manufacturing is flat in November - not declining. But on the clearly negative side, ISM's indexes for new orders and for backlogs were both below 50 - 48.7 for new orders and 46.5 for backlogs.

These surveys raise an interesting question. The most recent Beige Book from the Fed indicated that manufacturing was generally positive outside of autos and housing-related industries. Which is a better indicator - the private surveys or the Fed's contacts' For now, the data show manufacturing as flat and with new orders suggesting some possible negative production numbers ahead.

Price reports have been mixed. The Chicago purchasing managers report indicated that input prices remain firm with its price index at a high 60.2 in November compared to 62.5 in October. The ISM input price index, however, stood at moderate 53.5 compared to 47.0 in October.

Housing remains weak, still under downward pressure
What is the position of housing in terms of the outlook' Do recent numbers change the view of a weak housing sector' New and existing home sales moved in opposite directions in October but both stood at low levels. New home sales dropped 3.2 percent in October to a 1.004 million unit rate.

But perhaps more importantly, the supply of new homes continued to rise to 7.0 months in October from 6.7 months in September. This suggests that housing starts are going to remain sluggish until inventories are brought into line.

Existing home sales actually improved, rising 0.5 percent to a 6.24 million annual rate. But as with new homes, the supply of existing homes on the market rose - to 7.4 months from 7.3 months in September. October's supply is the highest level in 16 years.

Supply is weighing not just on construction but on home prices. However, we did see some improvement in prices for new homes in October. The median price for new homes jumped 13.9 percent to $248,500 in October. Price data are volatile but the October number indicates that weakness may be bottoming.

The median price of an existing home was unchanged month-to-month at $221,000 but is down 3.5 percent year-on-year.

While the percentage changes look extreme, the home price levels are still high. Nonetheless, the lack of sustained appreciation in home prices will not be helping to fuel consumer spending through home equity lines of credit as has been the case earlier in this expansion.

Construction weakness spreads to the nonresidential sector
As alluded to earlier, the mix of strengths and weaknesses in the economy is changing - at least for the current quarter. And one of the notable shifts is in nonresidential construction. Construction spending fell in October with weakness in both residential and nonresidential construction as overall construction spending declined 1.0 percent, following a 0.8 percent drop September. October's weakness was led by private residential construction which fell 1.9 percent after a 1.4 percent drop in September. Private nonresidential declined 0.7 percent in October, following a 0.6 percent decline in September. It appears that we will probably have a negative quarter for nonresidential construction for the fourth quarter in addition to residential investment being negative.

The bottom line
Last week, we clearly received economic indicators that on a net basis showed the economy slowing, specifically with housing still declining and with nonresidential construction at least temporarily turning negative and with manufacturing flat at best for now. However, these are all signs of a textbook soft landing. Housing and durables manufacturing are the more interest rate sensitive sectors of the economy and that is where we are seeing weakness first. With the strength in corporate profits, the downturn in nonresidential construction may turn out to be a temporary dip - but it is too early to tell. At least three factors currently suggest that the current softening is merely that - deceleration, not decline in the economy overall. First, the consumer sector is healthy. As long as the consumer is humming along, so will the economy. Second, even though the Fed has not eased, the markets have. Medium and long-term interest rates have come down substantially. In fact, equity markets are already upgrading homebuilder stocks due to expectations of a healthy housing market next year. Finally, the dollar has dropped substantially in recent weeks. This will boost U.S. exports - although the weaker dollar also puts upward pressure on import prices. Overall, this is a textbook picture of a soft landing. The remaining problem is that core PCE and core CPI prices remain stubbornly high. Core inflation is still substantially higher than the believed Fed target of 1 to 2 percent inflation. The Fed may well stay on hold longer than most expect for this reason.

Looking Ahead: Week of December 4 through December 8

Tuesday
Nonfarm productivity in the third quarter fell to no change from 1.2 percent in the second quarter. Meanwhile, unit labor costs were still strong at an annualized 3.8 percent pace, following 5.4 percent in the second quarter. With the upward revision to real GDP growth, we should get some marginal improvement with the revisions to third quarter productivity and cost numbers.

Nonfarm Productivity Consensus Forecast for revised Q3 06: 0.5 percent
Range: 0.2 to 0.7 percent

Unit Labor Costs Consensus Forecast for revised Q3 06: 3.2 percent rate
Range: 2.6 to 3.7 percent rate

Factory orders rose a 2.1 percent in September despite being held down by a 4.6 percent drop in non-durable orders tied to gasoline price effects. More recently, the advance report on durables showed a sharp drop in durables orders - 8.3 percent in October due to coming off the spike in aircraft orders in September. We can expect further declines in gasoline prices in October to add to October's overall weakness in orders. However, the nondurables decline may not be as steep as that for durables and could "pull" overall orders up to a lesser decline than for durables alone.

Factory orders Consensus Forecast for October 06: -4.5 percent
Range: -6.2 to -3.0 percent

The business activity index from the ISM non-manufacturing survey rebounded in October with a jump to 57.1 from 52.9 in September. Given the latest weakness in the ISM manufacturing index and in the Chicago purchasing managers' index, a number above 50 (the break-even level for positive growth) would give the markets reason for a little optimism about maintaining the soft landing.

Business activity index Consensus Forecast for November 06: 56.0
Range: 52.0 to 58.0

Thursday
Initial jobless claims jumped 34,000 to 357,000 in the November 25 week, the highest level in more than a year. The surge was blamed on seasonal adjustment difficulties during the holiday season.

Jobless Claims Consensus Forecast for 12/2/06: 325,000
Range: 300,000 to 345,000

Friday
Nonfarm payroll employment rose a moderate 92,000 in October while wage inflation came in at a strong 0.4 percent. The unemployment rate, reflecting a tight labor market, fell to 4.4 percent from 4.6 percent in September. While a moderate payroll jobs increase is needed to support a soft landing, the markets will be paying attention to signs of whether the labor market is remaining tight or showing any signs of softening. Fed Chairman Bernanke and other Fed officials have emphasized that tight labor markets are a concern. Also, with recent weakness in manufacturing as seen in durables orders and various private surveys, markets will be paying attention to factory jobs and factory hours worked. In October, manufacturing jobs fell by 39,000 while the aggregate index for hours worked in manufacturing was flat.

Nonfarm payrolls Consensus Forecast for November 06: 100,000
Range: 40,000 to 150,000

Unemployment rate Consensus Forecast for November 06: 4.5 percent
Range: 4.4 to 4.6 percent

Average workweek Consensus Forecast for November 06: 33.9 hours
Range: 33.8 to 33.9 hours

Average hourly earnings Consensus Forecast for November 06: +0.3 percent
Range: +0.2 to +0.3 percent

The University of Michigan's Consumer sentiment index for November slipped to 92.3 from 93.6 in October. Weakness was in the expectations portion of the index.

Consumer sentiment Consensus Forecast for December 06: 92.0
Range: 90.5 to 94.0