>>If the chip is not bad, the following can be the cause:
>>1) code not running.

How to make sure the code is running?

>>2) wrong SFR address (check generated machine code in assembler listing).

SFR seems to be ok.

>>3) hardware holding the pins up or down (cut a trace to test).

Some pins are not connected, and behave the same. (P1 is HIGH, P0 is a squarewave)

>>4) bad code.

code looks ok, just simply setting and resetting the ports in a loop

>>5) ignored assembler/compiler/linker errors or warnings.

no warnings/errors

>>the 89c557 has 32k of onboard flash,so you will have to tie
>>EA high so it uses internal memory. If you haven't you will get
>>the effect you see,the cpu is trying to fetch external data as Erik said.
>>Also cpu's produce squarewaves on pins if the watchdog is timing out.

EA is connected to /PSEN by a 3k3 resistor, and seems to be +5V
EW is +5V (active low, thus disabled)

the datasheet does not say anything about initialization, and very little about special functions.
Could it be the alternative functions on P0 and P1 are activated, causing the output?