After three years of decline, a robust recovery in the stock market should have been expected. However, the pace of equity appreciation is not likely to continue at the same pace in 2004 - even if economic growth is moderately healthy. In 1991, stock prices surged after declining in the recession year of 1990. However, the pace of increase moderated significantly in 1992. Certainly, stock prices rose but by a much smaller increment than in the previous year. It is likely that the same pattern will emerge in 2004 - unless a confluence of positive factors unexpectedly come together (i.e., a healthy appreciation in the dollar, the end to the Iraqi conflict, the capture of Osama bin Laden, and quickening employment growth that spurs additional consumer purchases and in turn corporate profits).

Opportunities always abound for equity investors. In 2004, it will be important to monitor economic variables more than ever since a resurgence in the economy could provoke Fed officials into raising interest rates. Right now, inflationary pressures are not evident and this will allow the Fed to remain on hold longer than they would under normal circumstances. Nevertheless, monetary policy is extraordinarily accommodative at this time - and it can't last.

Bond yields rise in 2003
Bond prices fell and yields rose in 2003 as the economy and stock prices rose more dramatically than expected during the year. At the same time, the Iraqi conflict, including the capture of Saddam Hussein, helped reduce geopolitical uncertainty and tension. However, terrorism remains a real threat to the U.S. and is one reason why Treasury yields did not increase more dramatically in the year. Treasury securities are safe-haven investments, and with the war on terrorism not yet won, this could put downward pressure on rates in the coming year despite a stronger economic environment and a sharp deterioration in the budget deficit.

While inflationary pressures have not been a problem to date, there is a chance that this could change in the coming year with stronger economic growth. Fed officials have insisted that the federal funds rate target is likely to remain unchanged for a while, but most economists predict that the Fed will start raising rates in the coming year. Furthermore, the Bush administration estimates that the federal budget deficit will amount to a record breaking $500 billion in fiscal year 2004. This points to heavy Treasury borrowing - and a huge supply of Treasury securities in the next several months. These factors portend higher yields in the months ahead.

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

Manufacturing - and employment - on the mend
The ISM manufacturing index jumped several points in December to 66.2 after having already reached a level of 62.8 in November. The improvement in the manufacturing sector, measured by the ISM, is remarkable when compared with levels from just six months ago. Among the ISM's components, the largest gains were in new orders and production. Both surpassed the 70 percent mark in December, suggesting healthy activity during the month. Perhaps even more promising was a second monthly gain in employment that brought this index to 55.5. Manufacturing payrolls have been declining for roughly two years. A turnaround may be in the offing.

Indeed, new jobless claims also point to signs of improvement in the labor market. Initial claims fell 15,000 in the week ended December 27 to 339,000, the lowest level in roughly three years! Given that this week included a holiday, one must take the result with a grain of salt. However, there is no question that the downward trend in new claims over the past four weeks is encouraging. Over the past nine weeks, weekly jobless claims have risen less than 360,000 per week five times. Claims were less than 380,000 per week in the remaining four weeks. This sets a new trend for claims relative to the August-to-October period. It bodes well for employment gains which are likely to accelerate in the coming months should claims continue their trend.

Existing home sales decline
Existing home sales declined for a second straight month in November after peaking in September at a 6.7-million-unit rate. At a 6.1-million-unit rate in November, these is no question that single family home sales remain strong and well above year-ago levels as consumers continue to benefit from low mortgage rates. Nevertheless, sales were down in all regions of the country for a second straight month, although all regions do remain above year-ago levels. A moderation in home sales will eventually lead to a reduction in spending on home furnishings and appliances.

The Bottom Line
Economic figures were sparse during this holiday shortened week. While home sales decreased from extraordinarily high levels, it is perhaps fitting that the baton has passed from the consumer to the manufacturing sector. The ISM manufacturing index continued its sharp climb in December, pointing not only to strength in production but also to recovery in manufacturing employment.

Looking Ahead: Week of January 5 to January 9

Monday
Construction spending rose 0.9 percent in October, the fifth straight monthly gain. Healthy gains in residential construction expenditures have helped to boost total growth in this sector. Given the November rise in housing starts, it is likely that residential construction will help lift total spending.

Construction spending Consensus Forecast for Nov 03: 0.7 percent
Range: 0.3 to 2.0 percent

Motor vehicle sales jumped 7.3 percent in November to a 13.5-million-unit rate after declining to a 12.6-million-unit rate in October. Domestic cars were sold at a 5.6 million rate, up from October's 5.1 million pace. Light trucks were sold at a 7.9-million-unit rate, up from the previous month's pace of 7.5 million units. During December, auto dealers typically try to clear inventories before year end. It remains to be seen whether sales will surpass last year's 14.9-million-unit pace.

Domestic auto sales Consensus Forecast for Dec 03: 5.9 million unit rate
Range: 5.5 to 8.2 million unit rate

Domestic light truck sales Consensus Forecast for Dec 03: 8.1 million unit rate
Range: 7.7 to 9.4 million unit rate

Tuesday
The business activity index of the non-manufacturing ISM survey fell back to 60.1 in November after reaching 64.7 in October. Despite the slight pull back, there is no question that activity in the service sector has been strong over the past several months. Even the employment index rose to 54.9 in November, its third consecutive monthly rise.

ISM non-manufacturing survey Consensus Forecast for Dec 03: 60
Range: 59.5 to 62

Factory orders jumped 2.2 percent in October after a 1.4 percent hike in September. A third monthly gain is not in the cards: durable goods orders dropped 3.1 percent in November - with large declines in both defense and nondefense capital goods.

Factory orders Consensus Forecast for Nov 03: -1.5 percent
Range: -1.2 to -3 percent

Thursday
New jobless claims fell 15,000 in the week ended December 27, hitting a three-year low of 339,000. But market players discounted the drop, believing that seasonal factors were largely responsible for the decline. Nonetheless, claims have declined for three of the four weeks of December, and that bodes well for December payrolls.

Jobless Claims Consensus Forecast for 1/3/04: 350,000 (11,000)
Range: 337,000 to 350,000

Consumer credit expanded by a meager $1 billion in October after surging $17 billion in September. Large fluctuations in consumer credit expansion each month are primarily due to changes in motor vehicle sales. November credit expansion could be larger than the October pace because of the 7% gain in domestic car and light truck sales.

Consumer credit Consensus Forecast for Nov 03: $4.2 billion
Range: $-2.5 to $9 billion

Friday
Nonfarm payroll employment rose 57,000 in November after downwardly revised gains in the previous two months. Recent declines in new jobless claims bode well for December payrolls. A small rise in employment, however, may not be enough to trigger a dip in the unemployment rate.

Nonfarm payrolls Consensus Forecast for Dec 03: 130,000
Range: 100,000 to 165,000

Unemployment rate Consensus Forecast for Dec 03: 5.9 percent
Range: 5.8 to 5.9 percent

Average hourly earnings Consensus Forecast for Dec 03: 0.2
Range: 0.1 to 0.3 percent