Mid-day Update

S&P 500 1,083.68 -1.37%
NASDAQ 1,889.18 -1.50%

Leading Sectors
Semis -.02%
Retail -.76%
Tobacco -.82%

Lagging Sectors
Gaming -2.70%
Iron/Steel -5.14%
Nanotechnology -5.68%

Other
Crude Oil 39.15 -1.95%
Natural Gas 6.23 -1.02%
Gold 376.30 -.71%
Base Metals 100.45 -2.73%
U.S. Dollar 91.80 +.74%
10-Yr. Long-Bond Yield 4.78% +.27%
VIX 19.99 +10.26%
Put/Call 1.33 +33.0%
NYSE Arms .80 +23.08%

Market Movers
ADSK -4.7% after announcing acquisition of Unreal Pictures and Citi SmithBarney downgrade to Hold.
BRK/A -3.0% after disappointing 1Q earnings.
C -3.3% after saying it will set aside $4.95B in 2Q to cover legal costs.
NAV -6.0% after JP Morgan downgrade to Neutral.
OSTK -13.0% after announcing 1.73M secondary offering.
STFC -14.0% after Gregory Shepard dropped his bid to buy 8M shares and instead will sell 1M to Carl Icahn for $13.
STI -6.9% after announcing the acquisition of NCF for $6.98B.
Chinese ADRs down across the board on continued worries over economic growth.

Economic Data
None of note.

Recommendations
Goldman Sachs reiterated Outperform on SPG, FDC, CSCO, KO, PEP, STZ and CLI. QSFT raised to Buy at Citi SmithBarney, $16 target. CEY raised to Buy at Citi, target $44. POWI cut to Sell at Bank of America, target $22. STI cut to Underweight at Prudential. LEA raised to Overweight at Prudential, target $70.

Mid-day News
U.S. stocks are falling mid-day on fears over rising U.S. interest rates and slowing Chinese economic growth. Kuwait is backing Saudi Arabia's call for more OPEC production, Dow Jones reported. Some cable executives have pledged not to carry former Vice President Al Gore's new 24-hour network, as they were angered by his attempts at price controls, the LA Times reported. U.K. Defense Secretary Hoon said there are strong signs that Iraqi abuse photographs the Daily Mirror published may be fake, Bloomberg reported. Delta Air said it may be forced to seek Chapter 11 bankruptcy protection unless the company is able to reduce costs, stem losses and raise capital, Bloomberg reported.

BOTTOM LINE: The Portfolio is up slightly today as my retail shorts are down more than my healthcare longs. U.S. stocks appear to have entered the "shake-out" phase, which should result in a more meaningful intermediate-term bottom. I am currently in the process of rotating out of a few of my more defensive longs and into some of the leading basic material, industrial and tech companies. I will likely increase market exposure into any further extreme weakness this afternoon or tomorrow.

Monday Watch

Earnings of Note
Company/Estimate
AH/.38
CVC/-.37
CHTR/-.32
FOSL/.20
PSUN/.16
SBL/.08

Splits
None of Note.

Economic Data
None of Note.

Weekend Recommendations
Goldman Sachs reiterated Outperform on EBAY, PXD, BAC, GDT, BSX and DTV. Barron's has positive columns on MCIA and WMB.

Weekend News
Oil & Gas Journal has an interesting article, saying that technology will increase oil reserves 3x-4x current estimates. Americans have conflicting emotions about the photographs of abuse at the Abu Ghraib prison in Iraq, with many disgusted at the images yet protective of U.S. troops, the NY Times reported. President Bush plans to intensify a worldwide effort to gain support for Israeli Prime Minister Sharon's plan to withdraw from the Gaza Strip and retain some West Bank settlements, the NY Times reported. U.S. companies that sell products overseas say opposition to the war in Iraq and any anti-Americanism hasn't led to a loss in sales, the NY Times reported. BMW, the world's second-largest maker of luxury cars, may expand its Spartanburg, South Carolina, plant to build a third model there, the head of production said. A blast in the Russian republic of Chechnya killed President Kadyrov, Russian President Putin said. U.S. state governments are reporting the strongest tax revenue and the most positive outlook for budgets since the stock market began to crash in early 2000, the Washington Post reported. Iran won't oppose any move by OPEC to raise production when the group meets in Beirut next month, Reuters said. IBM said it has developed client middleware that will help companies avoid using Microsoft's operating system, the Financial Times said. SunTrust Banks agreed to buy National Commerce Financial for $6.98 billion in cash and stock, Bloomberg reported. Asian stocks are falling tonight by the most in 2 ½ years on concerns over rising interest rates in the U.S. and slowing Chinese economic growth.

Late-Night Trading
Asian indices are sharply lower, -6.00% to -1.00% on average.
S&P 500 indicated -.48%.
NASDAQ indicated -1.0%.

BOTTOM LINE: The Portfolio is 25% net short heading into the week. I expect U.S. stocks to put in a short-term bottom on Monday or Tuesday as strong economic reports, stabilizing interest rates and good corporate earnings lead investors to bargain hunt. It is possible, looking at the carnage in Asian indices tonight, that U.S. stocks may be in the process of forming an intermediate-term bottom rather than short-term. If this is the case, I would expect to see less investor complacency and an extreme surge in volume on a broadly negative day. I will likely begin to add selective long positions into any extreme weakness tomorrow in anticipation of a short-term rally.

Chart of the Week

Amex Computer Networking Index(2 Years)



Bottom Line: The Networking Index is down 28.55% since its recent high on January 20, 2004. It is currently at the most oversold technical level since its bottom on October 8, 2002. The index should outperform this week as I expect Cisco Systems(CSCO) to report a good quarter and give an optimistic forecast.

Weekly Outlook

There are a number of economic reports scheduled for release this week as well as a few significant corporate earnings reports. Scheduled economic reports include the Import Price Index, Trade Balance, Monthly Budget Statement, Producer Price Index, Retail Sales, Initial Jobless Claims, Continuing Claims, Consumer Price Index, Business Inventories, Industrial Production, Capacity Utilization and the preliminary reading of the Univ. of Mich. Consumer Confidence Index for May. The Producer Price Index, Retail Sales, Initial Jobless Claims, Consumer Price Index and Consumer Confidence all have market-moving potential.

Wal-Mart(WMT), Target(TGT), Cisco(CSCO), Dell(DELL), May Department Stores(MAY), Federated Department Stores(FD), Kohl's(KSS), Cablevision(CVC), Disney(DIS), Computer Associates(CA), Analog Devices(ADI), Elan Corp.(ELN), Panera Bread(PNRA) and Tiffany(TIF) are some of the more important companies that release quarterly earnings this week. There are also a few other events that have market-moving potential. The Fed's Snow speaks at the Chicago Fed Conference on the Banking Industry, the Fed's Santomero speaks on the current economic outlook, the 2004 Electronic Expo and the Intel, Texas Instruments, Yahoo! and Qualcomm Analyst Meetings could all impact trading this week.

BOTTOM LINE: It is good to see investor complacency falling from very high levels as evidenced by the decline in the AAII Bullish % and the rising VIX and Put/Call readings. As well, Friday's sell-off had a "washed-out" feel to it as breadth was horrific, many tech stocks rose and volume was average. I expect to see an oversold rally begin on either Mon. or Tues. of this week as many stocks have come down too far too fast. Strong earnings, strong economic reports and stabilizing interest rates should provide the positive catalysts for the rally. I expect networking, semiconductor, basic material and industrial stocks to outperform this week, while restaurants, retailers and pharmaceuticals may underperform.

Market Week in Review

S&P 500 1,098.70 -.78% for the week.

U.S. stocks fell modestly last week as broad-based weakness in commodity and interest rate-sensitive shares outweighed relative strength in technology stocks. Rising energy prices and fears that the Fed is falling behind the curve with respect to inflation dominated trading throughout the week. Commodity-related stocks took another beating on comments by Alan Greenspan that a slowing Chinese economy would further pressure commodity prices. As well, a Bank of America downgrade of the oil service sector sent energy-related stocks reeling even as the price of crude hits its highest level since the Gulf War. The selling in the later part of the week seemed to climax on Friday as 3,185 stocks fell and 261 advanced on the NYSE. This 12-to-1 negative ratio was the broadest since Oct. 27, 1997. On this day, the S&P 500 ended an 11% slide and proceeded to rally almost 37% over the next 9 months.

There were also a number of positive developments throughout the week. Tyco, the world's largest marker of security systems, said second-quarter profit rose more than 600%. The company also raised its third-quarter and 04 forecasts. Royal Bank of Scotland agreed to buy Charter One Financial for $10.5 billion, sending the shares 22% higher, and said it will continue to hunt for U.S. acquisition targets. The Semiconductor Industry Association said it will soon hike industry growth forecasts to 20% for 04 and DRAMeXchange.com said prices for memory chips are rising for the first time in over a month. This resulted in a 3.05% gain for the SOX on the week, in a significant show of relative strength. This is important as this group had fallen 21.4% from its recent highs and led the entire market lower. Finally, block trades on the NASDAQ rose 24.3% from the prior week, implying that large institutions or "smart money" is moving back into technology shares.

Bottom Line: I believe fears of inflation, slowing earnings growth and a hard-landing by the Chinese economy are exaggerated. Most commodity prices are currently falling and the U.S. economy in not nearly as dependent on low oil prices as it once was. Crude Oil accounts for less than 5% of inflation. Almost 70% of inflation is derived from rising Unit Labor Costs, which are currently subdued. Furthermore, the U.S. dollar appears to be breaking up through its downtrend line that has held since February 02, which should further pressure commodity prices. Earnings acceleration has always peaked during the first few quarters of a recovery from recessions. Earnings are currently accelerating at the fastest pace on record. It is inevitable that growth will soon decelerate from these unsustainable levels. However, I find no empirical evidence of any correlation between decelerating earnings growth from very high levels and a significant decline in stock prices. Finally, investors seem to think that China has all of a sudden imploded, which is currently not the case. Any company that sells to China or benefits from Chinese economic strength has been ravaged over the last several weeks. I would recommend investors with a long-term horizon that are looking for a bit of international exposure begin to accumulate a basket of these shares at current levels. In my opinion, China is still in the early stages of a multi-year surge in economic growth that will yield huge benefits to companies that operate in the region.

Economic Week in Review

ECRI Weekly Leading Index 136.00 +.59%

Construction Spending rose 1.5% in March versus expectations of a .5% gain and a .1% drop in February. Moreover, total U.S. construction spending is rising at a record annual pace of $944.1 billion, as work increases on highways and other public works as well as private homes and office buildings. "We've been seeing an improving economy for the last year and a half and I think we're going to see improved occupancy in both apartments and offices," said Sam Zell, chairman of Equity Residential and Equity Office Properties, the largest office and apartment landlord in the U.S. Finally, Wienerberger AG, the world's biggest brick-maker, said it is spending $50 million in the U.S. to enlarge capacity at plants in Rome, Georgia; Brickhaven, North Carolina; Louisville, Kentucky, Bloomberg reported.

The ISM Manufacturing Index for April held near a two-decade high coming in at 62.4 versus expectations of 62.7 and 62.5 in March. Production increased and more factories added workers than at any time since 1987. "The combination of lean inventories, strong demand and a weak dollar is clearly leading to an underlying pick-up in factory activity," said David Greenlaw, chief U.S. fixed income economist at Morgan Stanley. The ISM Prices Paid Index rose to 88.0 in April, the highest since 1979, versus expectations of 85.0 and a reading of 86.0 in March. Finally, the Backlog of Orders Index rose to an all-time high.

Factory Orders for March rose 4.3% versus expectations of a 2.4% rise and .3% in February. This was the largest year-over-year increase since the stock market bubble burst in 2000, as the strongest economic growth since 1984 prompted companies to buy more machines, electronics and petroleum. Manufacturers had a record-low 1.23 months worth of inventories at the current sales pace in March. "With inventories low and firms finding it hard to gain traction to both meet demand and bring stocks to a more comfortable level, we can expect increased hiring and accelerated production," said Drew Matus, an economist at Lehman Brothers.

Federal Reserve policy makers voted unanimously to keep the benchmark U.S. interest rate at a 45-year low of 1%. "At this juncture, with inflation low and resources use slack, the committee believes that policy accommodation can be removed at a pace that is likely to be measured," members of the rate-setting Open Market Committee said in a statement following their meeting in Washington, Bloomberg reported.

The U.S. budget deficit may narrow to $370 billion this year, 29% lower than White House estimates, as a vigorous economy boosts tax revenues, economists at Citigroup said in a weekly report. "This sharp upturn in tax receipts has sweeping positive implications for the Treasury's financial position," the report said. State tax receipts are also rising as the U.S. economy expands. The National Conference of State Legislatures said last week that 32 states predict they will have surpluses this year. States had posted a record $78.4 billion in deficits last year.

The ISM Non-manufacturing(Services) Index rose to an all-time record of 68.4 in April versus expectations of 65.0 and a reading of 65.8 in March. "The economy is getting even better as business spending and hiring are driving things," said Robert Mellman, an economist at J.P. Morgan. Services account for 85% of the $11.3 trillion U.S. economy. The survey's employment index rose to the highest level since 2000, as well. Economic conditions "are extremely strong, really everywhere," Jeff Immelt, CEO of General Electric said. "We're seeing volume up in the U.S. and Europe in every one of our businesses."

Non-farm Productivity for the 1st quarter rose 3.5%, meeting expectations, versus 2.5% in the 4th quarter. Unit Labor Costs for the 1st quarter rose .5% versus expectations of 0.0% and 0.0% in the 4th quarter. "It's really labor that is the most important input and stable labor costs suggest little inflation and more willingness on the Fed's part to move very slowly" in raising rates, said Tim Rogers, Chief Economist at Briefing.com.

The Unemployment Rate in April fell to 5.6% versus expectations of 5.7% and a 5.7% rate in March. Change in Non-farm Payrolls was a positive 288,000 in April versus a 170,000 estimate and 337,000 jobs created in March. Change in Manufacturing Payrolls in April was a positive 21,000 versus a 5,000 estimate and 9,000 jobs created in March. The revised March figures showed that manufactures increased hiring for the first time in 42 months. Total job gains in the last two months were the most since early 2000, Bloomberg reported. Since the job market turned around in September, the economy has added 1.1 million jobs. "After March, it looked like payrolls were finally getting into synch with everything else. Now they've really caught up with what everything else was telling us, and that is the economy is growing at a really strong rate," said Robert McGee, chief economist at U.S. Trust. The economy is now projected to grow 4.6% this year, the most since 1984, Bloomberg reported.

Bottom Line: The main economic data points released last week were almost universally above-expectations and continued to paint a very strong picture of the current state of the U.S. economy. However, as each report during the week seemed stronger than the previous, investors began to sell bonds and send interest rates higher. The 10-yr T-note is now yielding 4.77%, the highest since July 2002. The long-term downtrend line in interest rates, dating back to 1987, is around 5.7%. I highly doubt the downtrend will be broken at this point, but a move near this level is possible, barring any significant negative jolt to world economic growth. Retail sales came in a bit below expectations last week, but this may be explained by extraordinarily good weather and a rush by consumers to spend their time buying homes and lock in relatively low rates before any further increases. Almost every commodity is currently falling in price with the exception of energy. This is troubling considering this is a seasonally weak time of the year for energy demand. Crude oil is now at its highest level since the Gulf War in 1990. However, the U.S economy is much less dependent on low energy prices than in the past. The International Energy Agency, in a recent report, estimates high energy prices are shaving only about .3% off of current U.S. economic growth.

Home sales should remain relatively robust as job growth accelerates, offsetting higher interest rates. The ISM and Factory Orders reports both point to an accelerated rate of hiring and production in the coming months. I am not sure of the extent to which a falling budget deficit will lower interest rates, but it is a very positive development nonetheless. Unit labor costs, the largest component of inflation, rose for the first time in a year, but remain at relatively subdued levels. The two blow-out jobs reports I anticipated have occurred, thus the Fed could move interest rates higher at any time from their current 45-year low emergency levels. Barring an intra-meeting move, the June 29-30 meeting will likely result in the first Fed rate hike. The Fed will probably raise rates by 50 basis points at this time. Overall, last week's data were very positive as the "jobless recovery" myth perpetuated by the mainstream media is no longer debatable. Historically, mild inflation has been good for stocks as companies regain pricing power, profits soar and hiring accelerates. The main worry I have at this point is that the media's obsession with negativity is hurting investor psychology, thus potentially creating a self-fulfilling prophecy of slower economic growth.