At the Washington, D.C. Money Show this week, I shared some interesting items with subscribers and others. Of the 1,008 trading days in the four-year Presidential Cycle, the worst six weeks on average started last Thursday. In addition, the two worst months of the year for stock performance are usually August and September. While history never guarantees a down market, those are strong headwinds for the bulls and foreshadow a light at the end of the tunnel in late fall.

The market so far this year has been tricky, having done a great job of pushing both the bulls and the bears to the sidelines, fluctuating between 1220 and 1295 on the S&P 500. Although the good earnings reports were expected, it was still possible they would push up stocks on days the news out of the Middle East or regarding oil prices weren’t too bad. But up until now, the bulls have been thwarted every time the S&P pushes up towards 1295, and the bears can’t seem to break it under 1220.

The situation is not made easier by the dilemmas faced by Fed Chairman Bernanke.

Even though he obviously wants to pause the Fed’s relentless rate increase, that is a hard sell when the inflation numbers are getting worse. The Chairman is right in that Fed policy hits with a lag, and it would be prudent to pause to see how much the economy slows from the interest rate increases already engineered. But the bond vigilantes are not likely to let him off the hook so easily, before he has been tested by a real crisis. So I think we are in for a Fed increase on August 8, and another at the September 20 meeting.

The good news is that should about do it. I said at the Money Show that this was my last presentation of “Bear Market Profits in Tech? Really?” for some time. The reason is that right in the middle of the San Francisco Money Show, October 16 to 18, Intel will report what should be their worst quarter of this downturn. On the theory that we should buy stocks when the blood is running in the streets, and in the expectation that there will be gallons of it flowing down Montgomery and Pine Streets by the Stock Exchange about then, the Intel report should create a bottom. One week later, just in time for the obligatory retest, is the October 24 to 25 Fed meeting. A pause then would set off the two year bull market that characterizes the last half of the Presidential cycle, with the biggest move from an October bottom through 2007.

In anticipation of the changing market winds, I still think the best move is to sell things you don’t want to own for the next couple of years on any near-term rallies, and decide what you want to buy in the September-October flush. I have a few new stocks I am working on, like Cerner (CERN), Cnet (CNET), Cree (CREE) and Harris & Harris (TINY), and I expect all of them to be meaningfully lower in October.

With earnings reporting season in full swing, now is the time to review our companies’ performance and guidance, to see what we want to buy more of, or perhaps if there are stocks we should sell. I can hardly think of a better place to begin than the most atrocious Wall Street reaction we’ve suffered so far.

Earnings on target? Check. Guidance raised? Check. Stock down 18%? What?

Packeteer (PKTR) acquired Tacit two months ago, and said the acquisition would be mildly dilutive this year and accretive beginning in next year’s first quarter. It was a great strategic acquisition, as I’ll discuss in a moment. About half of the analysts covering the stock reduced their estimates for the quarter to the 12-cent area, and half didn’t bother. PKTR reported $34.2 million in sales and 12 cents. CNBC, Bloomberg, Reuters and others averaged the reduced estimates with the unchanged estimates, declared the Street consensus was 14 cents, and that Packeteer had missed the mark. Coming as it did on a bad day in the market, the stock was shelled.

In the real world, the company grew 6% from the first quarter’s $32.3 million, with less than a $1 million contribution from Tacit. Sales were good in all regions, and the company hit its revenue goals. Packeteer expects modest growth from its traditional product line in the September, plus $3 million to $4 million from Tacit. I anticipate operating income will be 8% to 9% of revenues in the September quarter, increase to 11% to 12% in the December quarter, and return to Packeteer’s long term model of 16% to 18% in each quarter of 2007.

In the Q&A, management said they have not seen business or economic weakness and had a normally good third month of the quarter in June. Europe stayed strong, in contrast to many other tech companies that have reported a slowdown there.

Packeteer remains strongly cash flow positive. They paid $78 million for Tacit, and their cash balances fell sequentially by $62.3 million in the quarter to $72.4 million. Tacit is already a successful acquisition, and the combined companies have the leading solutions for branch office communications, applications efficiency, VoIP and other Web 2.0 services, and even virus protection. Due to the steadily improving quarterly results and the irrational drop in the stock, I am moving PKTR back to the buy side with a $10 limit, making it a Top Buy, and raising my 12 month target slightly to $17.

Avian Flu MegaShift

Bulgaria is culling chickens even before getting their lab tests back, and banned the export of poultry and poultry products after several hens died near the Turkish border. South Africa has culled 8,000 ostriches with bird flu. Thailand reported its first outbreak in poultry in eight months and announced they found no evidence that it had spread to people. The next day they said whoops, sorry, a teenage boy involved with fighting cocks died of H5N1. Turkey has three kids with bird flu.

Glaxo said their bird flu vaccine elicited a response in 80% of the people who tested it, which is better than Sanofi-Aventis’ 50%. I still think antivirals will be more useful than vaccines, in part because a version of H5N1 that goes airborne to infect humans easily probably will be different enough to require development of a whole new vaccine. Doing that in chicken eggs will take months.

BioCryst (BCRX) is on the verge of getting some good news that should have a very big impact on the stock. I’ve learned that before the end of the Federal government’s September 2006 fiscal year, it is likely to select BioCryst to receive funding to develop peramivir for avian flu preparedness. We’ll also get the results of four Phase I trials plus animal efficacy data on their seasonal flu and bird flu drug, peramivir, in the fourth quarter. Given the positive results this drug had in its first incarnation as an oral medicine being developed with Johnson & Johnson, it’s safe to expect all the safety data to be good.

BioCryst recently came under pressure after they submitted some minor amendments to their FDA application for a pivotal Phase IIb trial of Fodosine in T-cell acute lymphoblastic leukemia; the amendments will delay the start of the trial to the December quarter.

However, Fodosine is a breakthrough drug for blood-borne cancers, and there will be many papers on it at the American Society of Hematology (ASH) meeting in December that should move the stock.

As I’ve said before, this company has many other programs going for it. I am looking for a six-month delay in their filing an Investigational New Drug (IND) application for a hepatitis C agent, simply because they have identified some new compounds that look even better than the molecule they were going with — BCX-4678.

So here is the impressive list of expected upcoming milestones to drive the stock up:

Date	Product	Application	Event
Q3:06	Intravenous peramivir	Bird flu	Dept. of HHS  funding
Q4:06	Intravenous & oral Fodosine	T-cell ALL	FDA approves Phase IIb trial
Q4:06	Intramuscular peramivir	Seasonal flu	Begin Phase II trial
Q4:06	Intravenous peramivir	Life-threatening flu	Begin Phase II trial
Q4:06	Intravenous peramivir	Bird & seasonal flu	Results from 4 Phase I trials
Q4:06	Peramivir	Bird flu	Animal efficacy data
Dec. 06	Oral Fodosine	CTCL	Phase I/II data at ASH
Dec. 06	Oral Fodosine	CLL	Phase II data at ASH
Dec. 06	Intravenous & oral Fodosine	B-cell ALL	Phase I/II data at ASH
Dec. 06	Intravenous & oral Fodosine	Refractory T-ALL	Phase I/II data at ASH
Dec. 06	Intravenous & oral Fodosine	Refractory T-ALL	Begin pivotal Phase IIb trial
Q1:07	BCX-4678 or better drug	Hepatitis C	IND filing
Q1:07	BCX-4678 or better drug	Hepatitis C	Begin Phase I trial
Q1:07	BCX-4208	Psoriasis	Begin Phase II trial

That’s a lot of good news to send this stock skyward. BCRX remains a Top Buy up to $19, and you can see from this table why I think my $30 target is still reasonable.

Gilead Sciences (GILD) reported last Thursday after the Radar Report went out. It was a good quarter with no earthshaking news, and the stock is drifting up. The Street was looking for $666 million in sales and 54 cents per share, and the company came through with a record $685.3 million, up 38%, and 56 cents. (Pro forma, before options expense, they reported 61 cents compared to 41 cents last year.) The consensus for the current quarter has increased by $33 million in sales and 52 cents per share to $693 million and 56 cents per share — both probably low again.

Tamiflu royalties and contract revenues more than doubled from last year, thanks in part to the renegotiated contract with Roche. However, royalties were down sequentially due mostly to the seasonality of the flu season. HIV drug sales were strong, and the company raised their 2006 guidance (which now includes the launch of the recently-approved Atripla 3-in-1 pill) by $125 million to a range of $1.95 billion to $2 billion.

The company now has $3.3 billion in cash, up 30% from the end of March, in large part due to the $588 million they brought in from selling convertible notes. The January 2007 $60 LEAP (GDQAL) is under my $9 buy limit and is a buy for a $20 target as Atripla rolls out and the flu season starts again in the winter.

Biotech MegaShift

Biogen Idec (BIIB) beat estimates and gave a very positive outlook for the relaunch of Tysabri in the U.S. The drug has already relaunched in the U.K., Germany, Ireland and Sweden BIIB is training 2,500 physicians at 2,000 sites in the U.S. in the Tysabri safety program, to watch for signs of the progressive multifocal leukoencephalopathy (PML) that killed two MS patients when the drug was introduced the first time. Both of them were taking Biogen’s Avonex as well as Tysabri, and the FDA’s recent re-approval specifically bans taking Tysabri in combination with another MS drug. I would not be surprised if there is never another case of PML among patients on Tysabri, as it seems likely the combination was the problem.

The company reported $660 million in sales, well above the $638 million consensus, and 57 cents a share in pro forma earnings, blowing away the 49 cent estimate. Avonex and Rituxan showed double-digit growth, and Rituxan is now being prescribed for rheumatoid arthritis. Genentech, Biogen’s marketing partner, said sales of Rituxan hit half a billion in the quarter, and it is still growing in the mid-teens. Talk about a blockbuster!

Biogen will start Phase III trials early next year on BG-12, another MS treatment, but this one is a pill instead of a shot. The Phase II results were very promising. In addition, they are working with PDL BioPharma on daclizumab for MS, and with Genentech they are looking at the possibility of Rituxan being available to treat MS. So if things really work out well, there’s a possibility that the company will have as many as five products available for patients with MS. As management said: “This would really revolutionize the therapeutic options and strategy to treat MS.”

The company did not raise 2006 guidance from their prior forecast of $1.95 to $2.10 a share, in spite of the strength so far. They said that they have $200 million available for acquisitions this year, and have spent only part of it, so there will be more dilution coming as they pick up early-stage technology. That leads them to hold to the current guidance. At first the stock dropped a bit on this, but then it recovered nicely based on the strong metrics they showed in the quarter. I think Tysabri will be a smash hit right out of the gate. The January 2007 call (IDKAI) is a Top Buy up to $10 for my $21 target. And, the January 2008 contract (YZUAI) is a good buy up to $12 for a $23 target.

Millennium Pharmaceuticals (MLNM) reported this morning. They eared a penny pro forma, beating the consensus estimate for a two-cent loss. Revenues rose 8.5% from last year to $120.1 million, beating the $116.2 million consensus. Velcade revenues grew 10% from the March quarter to hit $58.8 million, up 34% from last year’s June period. They reiterated their expectation for Velcade sales of $225 million to $250 million this year, and said their pro forma net income for the year could be up to $5 million. The stock traded slightly lower after all this. The company said they are seeking in-licensing opportunities in oncology, and out-licensing all their molecules for non-U.S. rights, then finding U.S. partners for those that are not in oncology. Management added that the merger discussions they had last month were a one-time thing, and they have decided to stay independent.

I like the direction the company is taking under the new CEO, now at the helm for one year. MLNM remains a buy under $11 for my $23 target based on a series of in- and out-licensing agreements.

QLT (QLTI) also reported this morning, and the stock is up nicely for two reasons. First, they announced a Dutch tender offer for $100 million of their stock. Second, they finally laid out the case for combination use of their Visudyne with Lucentis, Macugen or any other of the anti-VEGF treatments for macular degeneration.

The Dutch tender offer is a way to return cash to shareholders. Shareholders can name the price they want for their stock, between $7 and $8 in 10 cent increments. Then the company accepts the price that will repurchase $100 million in stock, and everyone who bid that price or lower gets to sell at that price. Don’t even think about selling your stock at these levels! The company will retire about 15% or 16% of their stock through this tender offer, making your shares more valuable. And thy are only doing this because they think the stock is very undervalued. The tender offer expires on September 8 — read on to find out why.

Before I get to the combination use part of the story, the quarterly numbers were not great. Sales of $47.8 million were down 5.2% from the March quarter and down 24.6% from last year’s record quarter. Interestingly, the big hit to sales came in the December quarter, before Lucentis was approved. That’s because Lucentis is just a renamed and much more expensive version of Genentech’s Avastin, and doctors were already using it for macular degeneration. By the time Lucentis was approved on June 30, much of the market impact had already hit Visudyne.

QLTI reported 10 cents a share in earnings, down from 14 cents in March and 19 cents in the June 2005 quarter. For comparison, the consensus estimates were $47.5 million and 12 cents. The company still expects at least $370 million in Visudyne sales this year, but they cut the top end of the range from $400 million to $385 million.

Now, here is the problem with Avastin/Lucentis and any other anti-VEGF drug. They have to be injected into the eye. Visual acuity then improves. But as time goes by, it becomes harder and harder to inject into the eye, and patients hate it. But if they cut back from the therapeutic dose to a maintenance dose schedule, visual acuity immediately deteriorates. Visudyne is the only product that actually stops the bleeding that causes macular degeneration.

So the company is positioning Visudyne for combination therapy, to allow a lower maintenance dosing schedule of the injections without losing visual acuity. There should be data from the first large study (not done by QLTI) later this year. There are other, smaller studies underway, and we will see papers at the American Society of Retinal Specialists meeting in Cannes from September 9 to September 13 — right after the Dutch auction expires on September 8, ha ha — and in the American Academy of Ophthalmology meeting in November.

QLTI is thinking about initiating a study with Novartis, but I don’t see why they should. It is the makers of the anti-VEGF drugs that have a problem, and QLTI should let them pay for the clinical trials to prove there is a solution: Combination therapy with Visudyne.

With declining Visudyne sales for one or two more quarters, various legal expenses, efforts underway to sell their generic dermatology business and other cleaning up, they expect to report about 33 cents to 42 cents a share for the year. Legal expenses alone will be 15 cents to 20 cents a share. The company has about $450 million in cash, and is about to spend $100 million of that on the Dutch auction. They will still have plenty of ammo to win this war.

Given the timing of the tender offer and the fall presentations on combination therapy, any dip below $7 would be a gift. So I am moving QLTI from a hold to a buy under $7, and maintaining my $20 target. As we get closer to the end of the year, I expect to make it a Top Buy.

Content on Demand MegaShift

Comcast (CMCSA) reported this morning and the stock rallied nicely. They beat estimates for the right reason: They are gaining share in voice telephony, taking customers away from the Bells with a voice-video-data service delivered over their cable TV network. They reported $6.2 billion in sales and 22 cents a share. Wall Street was looking for $6.1 billion and 20 cents a share. They also raised their estimate for cable revenue growth to 10% to 11% (from 9% to 10%) and said their cash flow will now grow at least 13% (up from 9% to 10%). They added that instead of hitting one million phone customers by the end of the year, they would get to a range of 1.3 million to 1.4 million. And they added that the Adelphia assets they are acquiring will be slightly positive in 2006. The stock moved up $1.50 in response, and is over my buy limit. CMCSA is a solid hold for my $62 target.

Harmonic (HLIT) reported revenues below consensus, but the stock is up. The company had sales of $53.3 million in the quarter versus the consensus for $60.5 million, but it beat the earnings forecast for a one cent loss by reporting breakeven. For the second half of the year, they are expecting sales of $130 million to $140 million, or about $65 million to $70 million per quarter.

The shortfall was mostly due to $6 million in sales than have been delayed due to component shortages or falling behind on some IPTV projects. The satellite TV companies accounted for only 12% of revenues, but a big chunk of orders. The book-to-bill (orders-to-shipments) ratio was well above 1.0, which leads them to expect rapid growth in the second half of the year.

Harmonic also reported better than expected margins, and the combination of better margins and faster growth means they can earn five cents a share this quarter and eight cents in the December period — well above the consensus for two cents and four cents. Although the stock was up nicely today, I am making HLIT a Top Buy because the upturn is here, as shown by their orders. Buy up to $6 for my $12 target.

Silicon Image (SIMG) reported record revenues of $70.6 million for the June quarter, well above the Street expectation for $67.1 million. Pro forma earnings hit 19 cents a share, also above the consensus for 15 cents. Further, the company said that third-quarter revenue will be another record, about 10% above the June quarter, and they now think the year’s growth numbers will come in at 30% to 35%. If the September quarter is up 10% to $77.7 million or better, it will be $4.3 million over the current consensus. If the year is up 30% to 35%, revenues will be $276 million to $287 million, and the Street is at $274.6 million.

On the conference call, management said that their product book-to-bill ratio exceeded 1.3X and they ended the quarter with a record backlog and excellent visibility into the third and fourth quarter. During the June quarter, they formally announced the new HDMI 1.3 specification with support for deep color, higher bandwidth, a new high definition audio format, lip sync to match audio to video, a new mini connector to enable mobile devices like cell phones and much more. They pointed out that Sony’s Playstation 3 was announced with support for deep color, and SIMG shipped their first HDMI 1.3 products for revenue during the quarter.

The stock jumped over my $10 buy limit today, closing up $1.27 at $10.57. Although I am tempted to raise the buy limit to $11, I suspect the broad market will give you one more chance to grab it under $10 for my $18 target.

Zhone Technologies (ZHNE) reported a disappointing loss, as they continue to spend heavily on marketing their leading DSL and optical products, while revenues from their legacy products decline. Legacy revenues are declining faster than I expected, but the report was warped by a large one-time inventory write-off on those same products that made the bottom line miss look much larger than it was. Normally, Wall Street looks through a one-time write-off, but last Friday they took 29.5% off the stock, sending it under $1.50 per share. So either ZHNE is going out of business, or this is back-up-the-truck time and we can expect to see Dick Kramlich and New Enterprise Associates buying stock right along with us. Rather than keep you in suspense, Zhone is not going out of business. Here’s what happened in the quarter.

First, let’s quantify the real size of the miss. Consensus expectations were for $56.2 million in sales and pro forma breakeven, with a couple of pennies a share before taxes, depreciation and amortization (EBITDA). Adjusting for the inventory writedown, Zhone did $54.2 million in sales and lost 4 cents per share. EBITDA was minus 2 cents per share. So they did miss, by $2 million in sales and 4 cents per share. Whether that deserved taking 29.5% off the stock depends on how one reads their business opportunities.

Their Single-Line Multi-Service (DSL) product line grew units 35% sequentially to over 400,000 ports, a new record thanks to continued adoption of broadband data services, VoIP and Internet Protocol TV (IPTV). But price pressures held revenue growth to 6.4% sequentially. The optical business shot up 28.7% sequentially based on numerous 10-gigabit equipment buys. The company continues to expand their customer base, with 13 new customers in the quarter, spread around the world. But their legacy customers are also buying the new products, and sales of legacy products fell 14.9% from the March quarter.

Their costs were also above plan, as they spent on R&D for a possible win with a major carrier in the September quarter. That may or may not pan out, but it is a calculated gamble that won’t continue to impact the bottom line after the current quarter.

The company guided for sequentially flat sales in the September quarter, as DSL and optical continue to grow, and legacy products continue to decline. That was well below the consensus expectations for $60.4 million in sales, and was another reason the stock was hit so hard. Although Wall Street has not yet revised their earnings forecast for two cents per share, I’m sure they will be looking for a loss, probably in the 1 cent to 4 cent per-share area, and that is already built into in the price of the stock.

The bigger issue is that because legacy customers are moving to Zhone’s new products, the decline in legacy revenues is stalling sales growth and pushing out consistent profitability. In the June quarter, DSL was 65% of sales, while legacy and service revenue declined to 23% of sales from 28% in the first quarter. This shift can affect about two more quarters before it starts to lose relevance.

Investors will pay up for this stock when management shows consistent profitability. That should happen in 2007, with an outside chance that the December quarter is strong enough to start a string of profitable quarters. I recognize that I’ve been wrong on this before, as they should have been profitable a year ago. But when the legacy business gets small enough to stop dragging down the rapid growth in DSL and optical, the company can swing into profits. The company is outsourcing manufacturing of European DSL product to a Hungarian assembly house, Communication Test Design.

Zhone was able to grow cash in the quarter in spite of the loss, as well as pay down some debt. They guided for breakeven EBITDA in the current quarter. I am making ZHNE a Top Buy, not on timeliness, but on price. Average down now, before the insiders start buying again. I’ve trimmed the buy limit to $ just to reflect current market conditions, but I don’t think I should change my 12-month target price.

New World Economy MegaShift.

Click Commerce (CKCM) will report after this issue goes out on today. I am looking for $20.5 million in sales and 34 cents per share for the June quarter, with guidance for $21.5 million and 36 cents for September. I will cover the call in next week’s issue, unless something unexpected calls for a Flash Alert.

Security Megashift

@Road (ARDI) will report as this issue is being emailed out. I am expecting $25 million in sales and 2 cents per share for the June quarter. They should guide for about $27 million and 3 cents in the September period. I’ll send a Flash Alert if necessary, and otherwise will update you in the next Radar Report.

Gemalto (GEMP) reported this morning. The combined companies (Gemplus and Axalto) did $368.3 million in sales at historic exchange rates, down a modest 2% from last year, but also up 7.4% from the March quarter. They earned 3 cents per share, down from last year’s 5 cents, but ahead of the March quarter’s penny per share. They said the combined companies are on target for $108 million a year in cost savings by 2009.

They expect stronger performance in the second half of the year due to the usual seasonal increase in mobile communications revenues and deployments of many identity programs where GEMP already won the contract. There are price pressures in smart phone cards, but they are also winning a lot of contracts in China for the coming rollout of 3G cell phone service there. Overall cell phone card volume was up 40% from last year, but selling prices fell almost 30%. Financial cards grew volume 24%, but price pressures limited the revenue gain to 2%. All of the price pressures intensified after Gemplus and Axalto announced their intention to merge, as the smaller competitors try some desperation pricing to maintain market share. It isn’t going to work.
Buy GEMP up to $6 for my $12 target.

Symantec (SYMC) made their June-quarter numbers, maintained their September-quarter guidance and saw their stock rewarded for good 5% sequential growth in their consumer segment with Norton Internet Security. A coming product, Norton 360, could provide upside to their guidance. Veritas was in line with expectations, against tough comparisons. For the September quarter, SYMC guided for $1.28 billion to $1.31 billion in sales, compared to the consensus for $1.29 billion. They also guided for 26 cents to 27 cents a share; the consensus was 26 cents. For the year, they maintained revenue guidance at $5.2 billion to $5.4 billion, but slightly trimmed earnings to a $1.06 to $1.16 a share range. The midpoint of $1.11 was just below their previous midpoint of $1.14, but it didn’t hurt the stock because the consensus already was at $1.11. The stock reacted nicely today to this report, closing up $1.44. SYMC remains a hold as we look for an exit point before economic weakness brings down the capital spending outlook in 2007.

Video iPod MegaShift

PortalPlayer (PLAY) is also reporting as this week’s issue goes out. They should give a headline number of $35 million in sales and a 10 cent per-share loss, with pro forma earnings of about a penny per share. For the September period, I expect them to guide to a bigger loss in the 12 cent per-share area, as revenues decline to the $25 million level due to slowing iPod nano sales. The big questions, though, are not earnings, but whether the company has any opportunity to be in a high-end version of the new video iPod, when that might be coming, and whether they are working with Microsoft on their new Zune MP-3 player.

Microsoft is hinting that they will focus on community building, and I would not be surprised to see Zune be some combination of the iPod plus MySpace. With built-in Wi-Fi, users will be able to check other users’ playlists, buy and download music wirelessly, and use their computers to publish their playlists and comment on favorite bands and so on.

Wall Street is completely overlooking the community facet of Zune. If it is done right, it will get substantial market share away from Apple and be a big win for whatever company supplies the integrated electronics — which I expect to be PLAY. PLAY is a buy under $11 for my $20 target.

Market Outlook

If this market is going to fall apart, it will either rally to 1290 or son on the S&P 500 and then drop right through 1220, or it will fail right here and drop through 1220. At this point, either pattern could play out. But the key is breaking 1220 to the downside, which should take the market straight to 1185 now and eventually to 1040 in October. Expect a volatile, nerve-wracking ride in the short term, as Chairman Bernanke tries to play Whack-A-Mole with inflation while looking for a way to pause or end interest rate increases.

The excellent results posted by so many of our companies — Biogen Idec, Comcast, Harmonic, Silicon Image, Symantec — is the beginning of The Disconnect, where our MegaShift stocks outperform the rest of the market. But continue to hold cash, and even get ready to sell some things on any significant rallies.

Yesterday’s market action was really something. You won’t hear me complain about all the major U.S. markets closing up for the day or for a 200-point gain on the Dow. However, it will take some follow-through to convince me the downside is over. In addition to the “Bernanke Box” problem that I have talked about before and will discuss in the Market Outlook, geopolitical events are driving the market lower, in part directly and in part by inflating the price of oil. So, it is predictable that when those pressures subside the market will truly bounce. I am still expecting to see 1185 on the S&P 500 before that bounce happens, and then we should get a 100- to 150-point relief rally in the index. But the day after Labor Day often marks a market reversal, and by then the emphasis should be on slowing U.S. growth, estimate reductions and fear of third-quarter earnings reports. The deteriorating results at Apple, Wal-Mart, 3M, Disney and many other companies in almost every sector of the economy tell me that a widespread problem is about to raise its ugly head. That should be enough to take the S&P back down to set the year’s low around 1040, just about the time I hope to see you at the San Francisco Money Show, October 16 to18.

That’s the bad news.

The good news is that coming out of that low, we are likely to see a very strong market through 2007 and continued good news in 2008. The second half of a Presidential term usually is pretty good, with the third year (2007) often posting about a 50% move from the prior year’s October low to the closing high at the end of the year.

The even better news is that those who have been carefully tracking lagging indicators, like business capital spending and commodity prices, in the mistaken belief that lagging indicators have anything at all to do with a leading indicator like the stock market, will be dumping stocks in October due to the slowing economy. We’ll be able to buy stocks cheaply then, and the economy will slow rather sharply in the December 2006 and March 2007 quarters.

A recent CIO magazine survey showed that the folks who write the checks for new Information Technology equipment and software have already pared down their growth forecasts for the next 12 months from +8.6% to +6.9%, and they are usually almost the last group to get the word to cut back. But the stock market will head up in 2007, doing its usual forward-looking discounting of the improvements to come, and I’m predicting the Fed will finally be cutting interest rates, too late to avoid the weakness (also as usual).

But the best news of all is that the leaders of the next upturn are not likely to be the leaders of the last one. The commodity stocks are likely to take a breather until all the speculative holders are wrung out. Technology and healthcare have been underperforming for more than two years, and it is their turn to be in the limelight. A big upswing into and through 2007 will almost certainly be led by the NASDAQ, especially the semiconductor and biotech stocks. We will be there. I think our energy technology stocks will move with the tech sector, not the energy sector, because reducing or eliminating our dependence on the Middle East is now a strategic imperative.

So, with all this good news on the horizon, what should we do now? Well, our next course of action will be to use the relief rally over the next few weeks to trim any stocks that are not performing well, especially those related to capital spending. The last leg down in most bear markets is the worst, and a drop from the 1295 to 1325 range on the S&P in August to 1040 in October is going to feel pretty bad.

And, we are about to plunge into earnings reporting season, which means the next three Radar Reports will focus a lot on company detail and less big picture stuff. But that’s OK, because this is a crucial time to make sure our companies are on track — regardless of the market’s opinion, as expressed in the current stock prices — and to be sure we are focused on the very best ideas for the blast-off into 2007.

Avian Flu MegaShift

If you regularly eat goose intestines, you should abstain for a bit. Here’s why: On June 27, one of the Michigan raids on an Oriental food warehouse, which I talked about in the last issue, found five boxes (150 to 200 pounds) of goose intestines illegally imported from China. They were tagged for destruction. But when the USDA and Michigan health officials returned on July 5 — a mere eight days later — someone had replaced the goose intestines with chicken parts. The goose intestines are still missing, and are either in the refrigerator of someone who really likes this delicacy or were sold to Chinese restaurants somewhere in America.

The National Governors Association also recently released this advice to U.S. governors: Stockpile food in schools and prisons, and prepare facilities to quarantine people. The Department of Health and Human Services now says that in a pandemic 90 million Americans will get sick and 1.9 million will die.

My advice: Stockpiling food is OK, as long as it isn’t goose intestines. And for public relations reasons, please don’t refer to the quarantine facilities as “the camps.”

Just in case the H5N1 virus does get loose, Roche said that they now have 15 production partners in 10 countries to make more Tamiflu. They now have the capacity to produce 400 million doses in a year, which is double the 200 million doses governments have ordered, and would be enough to treat 6% of the people in the world. What the other 94% are supposed to do in the event of a pandemic, Roche didn’t say. But this was good news for Gilead (GILD) because it means more royalties sooner. The January 2008 $50 call LEAP (YGDAJ) went over my $16 buy limit, and because of that it is no longer a Top Buy, but you should continue to hold it for my $30 target. The January 2007 $60 LEAP (GDQAL) is still trading under my $9 buy limit and is a higher risk/higher reward position for a $20 target.

Crucell (CRXL) got some good news as Novartis said that they will build a $600 million flu vaccine plant in North Carolina that will grow the vaccines in cell cultures, not eggs. They are using $220 million of taxpayers’ money and expect to be able to produce 50 million seasonal flu shots and 150 million pandemic flu shots a year by 2011. By using Crucell’s cell culture technology, Novartis can make a new vaccine to cope with a mutating virus many weeks faster than an egg-based product. This is good news considering that if the bird flu rips through the U.S. chicken flock, there may not be very many eggs around. Novartis also submitted the first cell-based flu vaccine to the European Union for approval. CRXL remains a good buy under $28 for my $50 target.

Biotech MegaShift

Geron (GERN) is holding an analyst day today, so there should be lots of commentary tomorrow and next week. They announced that their stem cell product for spinal nerve regeneration passed preclinical safety tests, which was no surprise. Continue to buy GERN under $9for my $18target when positive clinical news or major media stories come out.

Reporting Season is in Full Swing Avian Flu MegaShift: BioCryst (BCRX) — August 2 (estimated) Crucell (CRXL) — August 29 Gilead (GILD) – July 20 Biotech MegaShift: Dendreon (DNDN) — August 9 (estimated) eResearch (ERES) — August 3 Geron (GERN) — August 3 (estimated) Biogen Idec (BIIB) — July 26 Millennium (MLMN) — July 27 (estimated) QLT (QLTI) — July 27 ViroPharma (VPHM) — August 2 China MegaShift: Huaneng Power (HNP) — no report scheduled UTStarcom (UTSI) — August 1 (estimated) Content on Demand MegaShift: Comcast (CMCSA) — July 27 Harmonic (HLIT)– July 26 Silicon Image (SIMG) — July 26 Telkonet (TKO) — no call scheduled, will file 8-K Zhone (ZHNE) — July 20 New Energy Technology: Connacher Oil (T.CLL) — about mid-August Fuel Cell Energy (FCEL) — August 28 (estimated) Gasco Energy (GSX) — August 2 Holly Corp. (HOC) — August 2 Infinity Energy (IFNY) — mid-August Ocean Power (OPWT) — mid-October Plug Power (PLUG) — June 26 (estimated) Royal Dutch Shell (RDS.A) — July 27 Rentech (RTK) — early August New World Economy MegaShift: Click Commerce (CKCM) — July 27 Security MegaShift: @Road (ARDI) — July 27 American Science & Engineering (ASEI) — August 4 (estimated) Check Point Systems (CHKP) — reported last Tuesday Gemalto (GEMP) — July 26 Packeteer (PKTR) — July 20 Symantec (SYMC) — July 26 Nanotechnology & Materials MegaShift: Integral Technologies (ITKG) — early October Video iPod MegaShift: PortalPlayer (PLAY) — July 27 WiMAX MegaShift: Airspan (AIRN) — August 2 (estimated) Alvarion (ALVR) — August 2 (estimated) MobilePro (MOBL) — August 14 (estimated) Terabeam (TRBM) — August 1 (estimated)

QLT (QLTI) said that partner Novartis announced sales of Visudyne, their macular degeneraton treatment, were $95.3 million in the June quarter. That was not a good number — it is down 10.7% from the first quarter, and down 26.1% from the second quarter of 2005. The company is losing market share because doctors are experimenting with other, newer drugs. Longer term, QLT needs to get doctors to try combination therapies including Visudyne, and also see the clinical trials finished for combinations with Lucentis and Macugen. I expect this to be the major focus of the earnings conference call next week, and I will update you then on their plans. Assuming that QLT is aggressive about these issues, I may put the stock on the Top Buys list after the call. However, until we hear what they plan to do, I want to move it to a Hold.

Content on Demand MegaShift

Telkonet (TKO) put out a statement yesterday in response to the falling stock price:

"We recognize that the company’s stock price in recent weeks has been under a lot of selling pressure. The company is not aware of any adverse business events that should affect the stock price. The company continues to aggressively pursue both contract and channel partner relationships. Our suite of FIPS-140-2 products has been approved for government use and we are finalizing installation procedures with a major Tier-1 systems integrator, which will permit the integrator to use the products on an existing contract. We continue to aggressively pursue additional government subcontracting opportunities. We are in various stages of commercial trials with companies using our commercial products. I have returned from my medical leave, have been and will continue to be engaged in the day-to-day operations of the company."

The hang-up with announcing the EDS deal (the “major Tier-1 systems integrator”) continues to be getting the formal award letter from the government, and Telkonet continues to think that is imminent.

One thing the company did not comment on, and I have urged them to do so, is the level of naked short-selling in the stock. Naked short-sellers go short a stock without borrowing it, as the law requires. They then “fail” to deliver the stock, and after a few days the broker will buy back their position. Then they promptly short and “fail” again.

The American Stock Exchange keeps a “Threshold List” of stocks where fails to deliver exceed 10,000 shares for more than five days in a row and the total fails exceed 0.5% of the outstanding stock. TKO has been on that list for 43 days, which is outrageous. Some hedge fund is shorting the stock, planning to cover when the company announces the strategic investor, in hopes there will be extra stock around. It is despicable behavior, in addition to being illegal, and I have urged the company to get to the bottom of it.

Also, I know there has been some confusion with a Canadian stock that has the symbol TKO — Taseko Mines — that put out some negative news on Monday when a joint venture fell apart. Fortunately, I think Telkonet with have a couple of good announcements by the end of the month. Squeezing the naked shorts should come next. TKO is a Top Buy all the way up to $5, and I see no reason to change my $15 target.

New Energy Technology MegaShift

Gasco Energy (GSX) has been held back by the current, relatively low price of natural gas, right around $6. There is a very temporary surplus of gas that both I and the futures market think is certain to disappear over the next few months. We bought GSX as an important supplier to the utilities in the Green River oil shale basin, because those utilities will be supplying huge amounts of power to Royal Dutch and others who need to heat the shale in order to extract the oil.

Gasco is a very successful exploration company, bringing in new gas wells about 20% faster than they deplete the old ones. With their reserves constantly growing thanks to a drilling success rate above 80%, their cash flow growth is accelerating towards 20% per year. They are strongly cash flow positive even at current gas prices. Just based on their current leases, they will be able to keep growing their drilling program for more than a decade.

At this point, they have about 77 billion cubic feet of proven reserves, with only a bit over 25% of that already developed. A whopping 97% of their reserves are natural gas, not oil, which is where we want to be for the oil shale MegaShift, and also makes them an attractive acquisition target. I’m adding GSX to the Top Buy list this week, so continue to buy GSX under $4.50 for my $9 target.

Infinity Energy (IFNY) hit a 52-week closing low today, just after they announced that they hired an investment banker specializing in energy deals to explore alternatives for developing their 1.4 million acres of oil concessions off the coast of Nicaragua. This is going to be a big deal that will put this company on the map, and it really is a freebie for us, because we are invested for their oil shale holdings. I’m also adding INFY to the Top Buys. It remains a buy up to $6.50, and my $9 target is just the first stop on what I think will be a huge winner over time.

Plug Power (PLUG) won a contract with Telefonica Moviles, the second-largest cell phone company in Venezuela, for an initial deployment of nine GenCore backup power systems in the Caracas area. This followed an eight-month test of a system that worked through several power outages, including one that lasted 12 hours.

Telefonica Moviles has 700 cell towers in Venezuela and 10,000 sites across Central and South America. Many of those sites can’t use generators or battery backup, some for noise reasons and some due to bad weather. This is a big win for Plug Power and means competing cell systems will have to do something to improve their availability during power outages. It is another showcase installation in a completely different industry. PLUG is a Top Buy up to $7.50 for my $15 target.

Rentech (RTK) partnered with Peabody Coal to build two coal-to-liquids plants — one in Montana and one somewhere in the Midwest, right at one of Peabody’s major coal mines. Each plant will produce 10,000 to 30,000 barrels a day of transportation fuel.  Reading between the lines, it looks like Peabody is paying most of the costs, with third party contractors to be shared, and Rentech will own half the project. This was a big, big win for Rentech, because Peabody is looked to as a leader in the coal industry. Not a single coal company missed this announcement.

RTK jumped 21% on the news, but drifted back under $5 today. I am making RTK a Top Buy on this news, while keeping the buy limit at $5 and the target at $11.

Security MegaShift

Check Point Software (CHKP) reported an in-line June quarter. Revenues hit $138.9 million, just under the $140.l2 million consensus, and pro forma earnings were right on the button at 32 cents a share. They guided the September quarter down a bit, but left annual guidance approximately unchanged. That means that they are planning to have a very good December quarter, showing about 20% sequential growth. While December is usually a good quarter, the growth tends to be around 11% to 12%. The company believes their new products, outside their traditional firewall area, will take off. It is a gamble.

For the September quarter, they guided to $135 million to $144 million in sales, compared to the consensus for $143.4 million. They also guided for 31 cents to 34 cents a share, and the consensus was at 34 cents. But for the year, they guided for $570 million to $600 million, and the consensus was at $580.9 million. The company expects earnings of $1.33 to $1.40, and the Street was expecting $1.36.

While I think capital spending on security will hold up during the second half of the year, it is likely to be hit next year in a softer economy. Therefore, I am moving CHKP to a Hold and suspending the target price. We will use this rally to sell the stock if we can get out gracefully before the next leg down into October.

Symantec (SYMC) was the subject of a negative story in today’s Wall Street Journal, but there really was nothing new mentioned. The Journal talked about how hard it was to merge two big software companies and referenced increasing competition from Microsoft. Management will respond to the merger consolidation issues on the conference call next week.

Veritas Software, which Symantec acquired, is subject to the same pressures as Check Point, and for the same reasons I am moving SYMC to a Hold and suspending the target price. These are both very cheap stocks, but they may be dead money in 2007, and our best chance to get out could come in the next few weeks, if the current rally continues.

Video iPod MegaShift

PortalPlayer (PLAY) should have OK earnings. Apple announced that they shipped 8.11 million iPods in the June quarter, down from 8.53 million in the March period. That was better than analysts were expecting, yet the fact that it was down really puts the pressure on Apple to settle the Burst.com lawsuit and get the new video iPods introduced. As I’ve said, if PortalPlayer is not the integrated chip in a new high-end iPod, then all of Apple’s competitors (including the new Microsoft MP-3 player) will consider using the PLAY chipset. Buy PLAY under $11 for my $20 target.

WiMAX MegaShift

MobilePro (MOBL) said that they are getting double-digit monthly revenue growth in their WazTempe Wi-Fi network. They have installed over 800 access points, and for now it is the biggest municipal Wi-Fi mesh network in the country. The usage growth is coming from both fixed customers and mobile, with the latter split into subscribers and temporary users that pay a daily rate. Although the stock has been battered by the market’s fear of anything small and the potentially toxic convertible financing, MOBL remains a leader in municipal Wi-Fi systems. Continue to hold.  

Market Outlook

Poor Ben. The stock market peaked in early May, and usually leads the economy by about six months. So, the Fed should be looking for a softening economy starting in November. The tools they have to shore up the economy work with a six- to 18-month lag, so they should have started cutting interest rates in May.

But Gentle Ben has committed to an explicit inflation target, and because inflation is a lagging indicator, it will be in his face for a few more months. The producer price index, reported Tuesday, was above expectations, but the components showing the inflation in the pipeline were downright scary. The trends in year-over-year changes of core prices, excluding food and energy, were:

	March	April	May	June
Consumer (headline)	1.90%	1.60%	1.60%	1.90%
Finished goods	1.70%	1.50%	1.50%	1.90%
Intermediate goods	4.40%	4.90%	6.30%	7.30%
Crude materials	13.30%	16.10%	26.70%	33.20%
Intermediate inc. energy	19.00%	18.50%	20.90%	19.10%
Crude inc. energy	12.50%	7.10%	14.90%	7.70%

The headline number for wholesale prices of consumer goods, +1.9% in June, is right at the top of the Fed’s 1% to 2% comfort level. Wholesale prices of finished goods are similar. But look at what is in the pipeline for intermediate goods — stuff that is being manufactured. The +7.3% number for June has to be worrying the Fed, because unless companies eat the cost increases and squeeze their profit margins, that +7.3% will show up in finished goods in future months. Then look at crude materials — and that doesn’t even include energy! Companies just can’t absorb a 33.2% year-over-year increase — they have to raise prices. Sheet steel prices rose 5.2% in June — not year-over-year, but in one month — to a 15-month high.  The prices of goods imported into the U.S. rose 0.7% in the month, after rising the same amount in May — the biggest back-to-back gain since the government began keeping records in 2001. It looks like the one-time savings from outsourcing manufacturing to China may be over.

Just for comparison, I’ve listed the price increases including energy for intermediate goods and crude goods. Remember, this was before the latest battle started in the Middle East, sending oil prices to record highs. Today, the consumer price index came in above expectations at +0.35 for the month. That’s the fourth straight month at +0.3%, the longest such run in 11 years. The year-over-year June increase was +2.6%, the largest since 2002.

How can Bernanke’s Fed even pause with these numbers? They can’t. It was obvious from Bernanke’s Congressional testimony yesterday and today that he would like to pause, and he is even tossing out the idea that because Fed policy works with a lag, he should be able to pause even with inflation this high. But the bond market would tank as their suspicion that Helicopter Ben is soft on inflation got some hard evidence. He’ll be raising rates at the August 8 and September 20 meetings. He should have room to pause by the October 24 meeting, and at the December 12 meeting I think he will revert to the tradition of not raising rates during the holiday season.

Intel will report third-quarter results after the close on October 17. That is highly likely to mark the bottom for the market, as analysts give up on 2006 and start looking forward to 2007. A bit of a rally and then a retest a week later on October 24 would be the perfect scenario for the Fed to announce a pause and set off a 50% rally to 1560 or so on the S&P 500 by the end of 2007. Market events rarely unfurl exactly as expected, but this is the most likely scenario given the data we have today.

Top Buys

Additions: Infinity Energy (IFNY): I’m adding INFY to the Top Buys because they are about to monetize their Nicaraguan offshore oil concessions.

Gasco Energy (GSX): I’m adding GSX because the price of natural gas should be about to start a steep climb from $6 to $12 an mcf over the next six months..

Rentech (RTK): I’m adding RTK because their showcase deal with Peabody Coal will accelerate their technology licensing activity.

Deletions: Gilead January 2008 $50 LEAP (YGDAJ): I’m deleting YGDAJ from the Top Buys because it crossed over my buy limit this week.

Over the past five months, I’ve been telling you that the market has been set up for a serious decline through the end of 2006. If you’ve followed my advice, you should be in great shape to not only weather the storm, but come out the other side on the plus side. However, no matter how prepared we are, it is going to be difficult to watch the market drop double digits in pretty short order. The best defense we have is to understand our investment landscape. To that end, there are a couple of key factors having an effect right now that I want to discuss today.

Earnings, Inflation & PC Sales

Next week begins the earnings deluge, which should be the last chance that the bulls have to push stocks up until September-quarter earnings are reported in mid-October. During this time, I will be watching not only our stocks but all the various industry leaders to see what develops.

So far, earnings season is off to a shaky start. Even though I am negative on the market outlook, I thought that June-quarter earnings would be strong. And with the economy slowing as quickly as it has, I thought at least September-quarter guidance would be cautious, with some companies even expressing caution for the December quarter, too – signaling all is not well in Denmark.

This outlook, of course, isn’t good news for the bulls. It is vital for the bullish case that stocks rally strongly off their earnings reports. Some have — Standard Microsystems was rewarded for good numbers, and KLA-Tencor said orders are strong for semiconductor equipment, which pushed up both it and Applied Materials. But those are very late-cycle, cyclical companies, and it isn’t surprising that they aren’t seeing any weakness yet.

What has been a bit surprising, though, is the revenue misses at Lucent, Advanced Micro Devices, 3M, SAP, Cree, Fastenal and Brunswick, all of which also indicated a disappointing September quarter, too. EMC and Genentech also missed, but they held out more hope for September. Genentech posted a 79% rise in profits and raised its full-year earnings growth outlook, but the stock was pummeled anyway. That may be a sign that we are in an environment where almost no matter what a company reports, the stock goes down.

The background to this round of earnings reports is what the Fed is doing. Chairman Bernanke and friends intend to keep inflation in check, which traditionally means inflicting pain on the economy by making it difficult for businesses to raise prices. If consumers are squeezed to the point where they can’t or won’t pay more, and maybe start reducing their debt instead of borrowing even more to spend, businesses will have to go back to their suppliers to get costs down.

Add that on top of Bill Gates saying that there is only an 80% chance that Windows Vista will be ready to ship in January. This will likely put a real damper on PC and server sales for the rest of the year, with an additional impact on semiconductor sales. It’s no wonder that Dell is at a multiyear low. So far, cell phone sales have held up better than I thought they would, and I will be scrutinizing earnings reports in that area especially close for signs of weakness. The big disappointment at Cree that clobbered the stock today, combined with Samsung’s poor report this morning was blamed on handset sales and price cutting. This tells me that there are inventory problems in the channel. Inventory problems are caused by people not buying. If cell phones are going to follow personal computers into a weak period, semiconductor earnings estimates are much too high, and there is still a lot of pain to come in tech stocks, not to mention the broad market.

So, in this environment, and because it is hurricane season, we’ve been building up only our New Energy Technology MegaShift investments, while holding cash from our February sales of legacy tech stocks. I’m still watching the solar and ethanol stocks for a better entry point, but I think further investments in the energy area should be on hold for now. These companies, as with many of our MegaShift stocks are in the early stages or development stages of their business. These kinds of stocks reward risk independent of the market when the news is good, but can be hit when it isn’t. So, I’ll continue to keep you updated on each of their movements during this volatile time in the market. With that said, let’s take a look at the recent news affecting our MegaShifts.

Avian Flu MegaShift

Along with high energy prices and the drive for alternative forms of energy, one of the surest MegaShifts we are invested in is heavy government spending to prepare for a bird flu pandemic. Yesterday’s news that frozen poultry meat from a bird flu-infested areas of China was smuggled into Michigan for sale to 300 Chinese restaurants and grocery stores brought the story even closer to home. The virus can survive freezing very well — actually, it is the best way to preserve the virus indefinitely. The thawing process completely reactivates it.

However, the story lacks a few important details, so far:

• Federal officials learned of the problem in early June, but didn’t alert state officials until June 20. Why?
• Federal officials seized birds from the warehouse on June 27 and destroyed the meat without testing it first. Why?
• While Federal officials destroyed those birds, they left a portion in the warehouse for "safety reasons." Why?
• State officials learned of the problem on June 22, but state and federal officials didn’t make a second raid on the warehouse until July 6. Why?
• The remaining meat was seized on July 6, but they found that some of the quarantined food had been switched. So, how much of this was sold to restaurants and grocery stores?
• All together about 2,000 pounds were destroyed without being tested. Why?
• Officials admitted that consumers “probably” have eaten some of the poultry, but as long as it was “properly cooked” they should not be alarmed. What are the odds that it was all “properly cooked?” Were all food preparation surfaces disinfected with soap or bleach, as recommended? Did everyone involved in the preparation wash their hands frequently to prevent the spread of any virus, as recommended?

The emergency management coordinator for the Michigan Agriculture Department is sending inspectors to the customers, in hopes of finding some unconsumed poultry that can be tested to “reassure the public.” And in regard to not telling people what was happening, he said: “One of the reasons we haven’t been public is because it’s the USDA’s investigation. The delicate balance of food safety is trying to let people know about threats and risks without unduly scaring them.”

What would scare me is realizing that the state would keep it secret for three weeks that contaminated poultry might have made it to some grocery stores and restaurants. “Delicate balance,” indeed. Sadly, this is probably what we can expect from our “leaders’ in future bird flu incidents — we will find out too late or not at all about these situations.

After last week’s confirmed outbreak in Spain, the UK decided to stockpile 10 million doses of a bird flu vaccine — not for people, but for chickens. That is the surest way I know to make the H5N1 virus mutate into a vaccine-resistant form. China is making the same mistake. The Chinese government also said that they will boost health care spending in rural areas by $1.25 billion, in part due to H5N1. That comes to 10 yuan per person, which is not enough to buy a box of aspirin, even at Chinese prices. Hospitals in China require families to deposit the estimated cost of treatment in cash before they will admit a patient.

Meanwhile, the death toll continues with an 18-year-old woman in Egypt, and a 3-year-old girl in Indonesia. The deputy director of the United Nations Food and Agriculture Organization is realistic. At the Geneva bird flu conference, he said: “Highly pathogenic avian influenza poses a continuing threat and we must brace ourselves to go on fighting it, quite likely for years.”

We’ll be out of these stocks at significantly higher prices before then, but this should make it clear that avian flu truly is a MegaShift, not a fad. In order to make more Tamiflu, invented by Gilead Sciences (GILD), Roche will be shipping oseltamivir, the active ingredient, to a Cardinal Health plant in Germany to make gelatin capsules of the drug. More production equals more royalties for Gilead. GILD will report earnings after the close on July 20, and I am expecting strong sales of Truvada (which combines Viread and Emtriva in a single pill for HIV) and the weaker U.S. dollar to drive revenues and earnings above the consensus for $662 million in sales and 53 cents a share in earnings. September-quarter guidance should also be above consensus as Tamiflu royalties flow through with a one-quarter lag, and the company may raise its guidance for all of 2006.

Yesterday, Gilead and Bristol-Myers got U.S. approval for Atripla, the HIV three-in-one, once-a-day combination drug of Truvada and Sustiva, and that is the end of near-term pipeline news. Now, it is just a question of rolling out the new combination drug, which will be available within seven business days for $1,151 a month wholesale, and collecting accelerating Tamiflu royalties. Gilead and Bristol-Myers are negotiating with Merck to sell Atripla outside the U.S., and once they have a deal, they will file for European approval. The FDA said that they will consider Atripla for use in 15 developing countries, many in Africa, under President Bush’s five-year, $15 billion program to treat two million people in those countries infected with HIV.

Continue to buy the January 2008 $50 GILD call LEAP (YGDAJ) under $16 for my $30 target. The January 2007 $60 call LEAP (GDQAL) is a higher risk and higher return buy under $9 for a $20 target.

BioCryst (BCRX) presented Wednesday at the Untergerg, Towbin Emerging Growth Conference, and the webcast is archived on the company’s web site at www.biocryst.com. BCRX is finishing Phase I trials for peramivir now, with the goal of being in Phase II trials in the U.S., Europe and Asia during the coming flu season, with both intravenous and intramuscular formulations. Peramivir has been studied in over 1,500 people to date, and it has been the subject of more than 20 peer-reviewed papers. It outperforms Tamiflu in mice, and we will see how it does in human trials.

In addition to peramivir, in the next 12 months BCRX expects to initiate pivotal trials of Fodosine in T-cell leukemia and cutaneous T cell lymphoma (CTCL), initiate Phase II trials of BCX-4208 in psoriasis with Roche, and initiate Phase I/II trials of BCX-4678 in hepatitis C. As you can see, this is not a one-trick pony. BCRX is a Top Buy up to $19 for my $30 target.

Crucell (CRXL) announced Invitrogen as a technology partner in providing cell-based vaccine production systems. This is the first of many partners Crucell will assemble to deliver the equipment and services that will completely change the way vaccines are made and used. CRXL remains a Top Buy up to $28 for my $50 target.

Biotech MegaShift

Biogen Idec (BIIB) will report earnings on July 26 before the market opens. They hired away the president of Schering-Plough’s research institute to be president of R&D at Biogen. Coming after the March hire of a top cancer drug developer from Amgen, BIIB obviously plans to keep up the new product pace.

Genentech’s June-quarter report included a very strong $526 million of Rituxan, a good $15 million to $20 million above the consensus. Rituxan is a Biogen/Genentech drug, so this bodes well for Biogen’s June-quarter sales. The extra sales of Rituxan should cover some of the pre-launch expenses for Tysabri. The January 2007 call (IDKAI) is a Top Buy up to $10 for my $21 target. And, the January 2008 contract (YZUAI) is a good buy up to $12 for a $23 target.

Metabolic Pharmaceuticals (MBP in Australia, MBPLF on the pink sheets) announced in a peer-reviewed paper published in Experimental Cell Research that their collaboration with Neuron Pharmaceuticals discovered a new class of therapeutic brain peptides, Neural Regeneration Peptides. These peptides regenerate nerves in cases of peripheral neuropathy (a failure of the nerves that carry information to and from the brain, which results in pain or numbness.), often caused by diabetes or chemotherapy. There are no existing drugs that treat this condition — only the symptoms are treated.

Metabolic will start two Phase 2A trials of its pain drug this quarter. The obesity drug remains in Phase 2B dosing trials. Buy MBP below 75 Australian cents, or MBPLF below $0.56, looking for a $4 target over the next few years.

ViroPharma (VPHM) hosted a conference call this morning to discuss their recent scientific supplement filing to their petition for a stay of action regarding the new FDA rules for generic Vancocin. They put up several arguments in three areas, but the real purpose here is to raise the possibility of illness or death from a generic that is not thoroughly tested. That puts the FDA in a very exposed position if a badly-performing generic got to the market. When bureaucrats are in an exposed position, they usually give up. That’s what I expect this time, and that announcement alone would double the stock. Buy VPHM up to $13 for my $28 target.

China MegaShift

China’s stocks are getting hit hard because many companies are doing initial public offerings, which drains capital from the market. A lot of these are state-owned banks, which are about the worst-managed black holes for capital on the planet right now. But the suckers love ‘em, and as long as they pop for the first few days, that’s where the action is. Meanwhile, already-public stocks are slip-sliding away.

The economy continues to roar along, with a new record monthly-trade surplus of $14.5 billion in June. That guarantees continued fiscal and monetary pressure from the central government, as well as continued international pressure to let their currency float up. At some point, we will want to get heavily reinvested in China to benefit from the rising yuan, but not yet. We should wait for further government actions to slow the economy, and expect a stock market decline in the U.S. to have a magnified effect in Asian markets.

Huaneng Power (HNP) has a tough time going up when the price of oil is soaring, as the government regulates electricity prices and has been slow to raise rates. A slowdown will benefit HNP and let them get caught up on rates versus costs. Continue to buy HNP under $30 for my $45 target, and don’t forget their showcase “green nuclear” generating plant is under construction.

UTStarcom (UTSI) may benefit from what looks like a much slower than expected rollout of third-generation (3G) cellular service based on the CDMA standard. UTStarcom’s PAS system equipment lets carriers provide wireless service for less than 20% of the cost of 3G cellular. Meanwhile, they are installing Internet Protocol TV networks (IPTV) in several Chinese cities.

I had a question from Paul: “What do you think about IPTV as a technology? Specifically, what do you think about eWAN 1 (EWAN.PK)? The company plans to offer global access to ‘unbundled channels’ via the Internet and their proprietary technology. Does this sound like a winning idea?”

eWAN 1 owns a cable system, and they plan to rebroadcast that over the Internet to a set-top box that they have developed for TV sets and a mini set-top box for computers. It’s an interesting idea, but this is a five-cent stock, up from half a cent this time last year but down from 14 cents in March, with a total market capitalization of only $370,000. eWAN 1 says that they offer customized next-generation solutions to major corporations across the U.S. in the areas of high-speed Internet access and data warehousing, as well as video services. That’s a lot for a very little company, especially one with no current financials. I would rather own UTSI. Buy UTSI under $9 for my $15 target.

Content on Demand MegaShift

Harmonic (HLIT) said that they will report earnings on July 26 after the market close, and they made no negative preannouncement. Today they announced that a new direct-to-home satellite TV service launched in Australia, using Harmonic’s MPEG-2 compression and multiplexing solutions. It’s always hard to call Harmonic’s earnings, because they and we never know what will be accepted in time to be booked as revenues, and their customers are very large with lumpy shipment schedules. However, I suspect that they will beat the consensus expectations for $60.5 million in sales and a 2 cent per share loss. Buy HLIT up to $6 for my $12 target.

I had a subscriber question on Portal Software (formerly PRSF, but now acquired by Oracle). Steven asked: “I missed the sell on Portal Software. Oracle said it had received enough shares of Portal to proceed with its acquisition of the company. For those who still own PRSF, what should we do?”

Just tender your shares. This was a cash acquisition, and Oracle put money in the bank to cover untendered shares.

I also had a question on Silicon Image (SIMG) from Rich: “Michael — just read a report on baystreet.com regarding SIMG. They just downgraded the stock to a #4, or DANGEROUS/HOLD, claiming their profit outlook is weak. That flies in the face of yesterday’s positive earnings news and forecasts emanating from their annual analyst day. What gives?”

This downgrade was made by www.newconstructs.com, which runs a computer model to make their ratings. Their model is based on historically reported information, not on forecasts. They picked up the negative cash flow from investments in the March quarter and said: “Economic profits are not positive.” They divided the last four quarters of earnings, including the March-quarter non-recurring loss of 10 cents per share, into the current price and concluded: “The valuation is expensive.”

However, I think the company will report 16 cents a share this quarter, and then 20 cents for the holiday-influenced September and December quarters. That’s 69 cents for the year, and 13.5X this year’s earnings seems dirt cheap for a company growing 20% to 22% a year. Buy SIMG now that it’s finally come down under my $10 limit, and look for an $18 target after the holiday season. Newconstructs can then upgrade the stock due to their positive cash flow and strong earnings.

Telkonet (TKO) got a reiterated buy recommendation from JMD Securities this week, calling the recent weakness a buying opportunity for a $6.25 target. They pointed out increasing business at the Microwave Satellite Technologies subsidiary, as well as sales of Broadband-over-Powerline systems to the U.S. government. The letter from the government covering the EDS systems still has not been received, nor has there been a strategic financing announcement or a new CFO appointment. These are the reasons the stock has drifted lower, and the first two should be resolved within 30 days and the CFO within 90 days or so. TKO is a Top Buy up to $5 for a $15 target after these issues are resolved.

New Energy Technology MegaShift

With the price of oil soaring to new records due to kidnappings in Nigeria, bombings in Mumbai, a shooting war between Israel and Lebanon, and uranium enrichment in Iran, the energy sector is one hurricane away from completely disconnecting from the rest of the market. After last year’s hurricane season, we can be sure that hurricane is coming, which is why I want you to build a significant stake in these stocks now. Even in a bad down market for everything else (perhaps caused in part by soaring oil prices that tie the Fed’s hands), I expect all of these stocks to be substantially higher by mid-October.

Connacher Oil & Gas (T.CLL) was hit a bit but bounced right back after Shell Canada said that expanding the Athabasca Oil Sands Project would cost billions of dollars more than earlier estimates due to increased costs of labor, materials and equipment. Some companies building projects at the end of the decade are even worrying about greater competition to hire a work force from another major construction project, the 2010 Winter Olympics in Vancouver.

But Connacher is OK because the further along a company is with their project, the better off they are — and Connacher will be producing substantial oil by the middle of next year. Today, they received final approval for their Great Divide Oil Sands project, and they expect to construct their plant and drill the first 15 pairs of wells in the September and December quarters, which will produce oil for six to eight years. (The whole project should last for at least 25 years.) They’ll start their 10,000 barrels a day plant during the second quarter of 2007, about four months behind schedule due to the length of the regulatory review.

Connacher also added 15% to their budget to cover increased expenses — a far cry from Shell’s “billions of dollars.” They will invest in a pipeline to their Great Falls, Montana refinery, which along with a few other new items increased the budget another 14%. The company will raise $165 million in project financing and to repay the bridge loan they used to buy the refinery from Holly Corp.

In a direct comment on what Shell said, management of Connacher pointed out that:

“The company wishes to distinguish its Great Divide project from the large mining
projects which have been the topic of extensive press commentary in recent days and weeks. SAGD projects, such as Connacher’s 100%-owned Great Divide, will have much shorter lead times with much lower overall capital requirements, smaller vessels and greater efficiency in comparison to the announced large-scale mining ventures.

“Many of the popular press articles and some comments on rising costs in the oil sands by some more engaged analysts or investment industry spokesmen have failed to make this distinction.

“They have also failed to identify and distinguish the different comparative operating cost regimes for SAGD operations and mining. SAGD plants will increasingly be accompanied by an emphasis such as that adopted by Connacher, emphasizing a modular approach to plant construction. SAGD plants also have a smaller environmental footprint and should be able to avoid many of the diseconomies that may characterize more remote and larger scale mining operations.”

Connacher also said that they are doing more evaluation work to find more drilling spots in the Great Divide project, and they will be announcing results of those studies between now and yearend. I expect them to find many more opportunities to either increase daily production or extend the life of the project, with each positive announcement pushing the stock higher. T.CLL is a Top Buy up to $4.50 for my $7 target, as they start to produce oil from Canadian tar sands using their steam-assisted gravity technology.

I received an email from John: “I haven’t seen anything on refineries. Are there any stocks you like with an edge in this area? I have read that capacities in this country are very limited, and with demand rising throughout the world I have to wonder as to the position there in as well.”

John, that was behind my recent recommendation of Holly Corp. (HOC), which specialized in refining sour or heavy crude. Many people don’t know that when Saudi Arabia says they can expand production to help keep oil prices down, it isn’t quite true. The oil they would go after is very sour, and not many refineries can handle it. HOC gave us a few days to get in, and then took off. I’ll raise the buy limit on HOC when it retreats a bit, so you get a second chance to get on board. For now, continue to hold HOC for my $52 target.

Plug Power was victimized by HBK Investments, a hedge fund that sold the stock short to drive down the price before investing in a private placement. I often talk sarcastically about the mysterious drops in stock prices that happen before these deals. I’m not surprised it happened; I’m just surprised they were caught. The SEC seems to be catching on, as they have fined Langley Partners and Knight Capital’s Deephaven Capital Management $22 million for the same game. I’m just sorry they don’t bar these folks from the securities business for life.

Three other hedge funds are being investigated: Alexandra Investment Management, Gryphone Partners and Cornell Capital Partners. Remember that last name when we get to the MobilePro update, below. I think PLUG has a good suit against HBK.

In happier news, the company installed two GenCore backup fuel cell systems at the headquarters of the New York State Energy Research and Development Authority. Buy PLUG up to $7.50 for my $15 target after the hurricane season and more new order announcements.

I received an email from Jake regarding Rentech (RTK): “How does their technology compare to Headwaters (HW) for producing synthetic fuels? Thanks for your great work.”

Thanks for the comment, Jake. Headwaters is very dependent on revenues from entities that convert coal dust into a synthetic fuel briquette to be burned by utilities, using Headwaters technology and chemicals. This is a business that depends on tax credits tied to average oil prices, and they expire at the end of 2007. Many producers can’t claim the credit when oil is over $58 a barrel, so they shut their plants and stop buying chemicals from Headwaters. That’s why HW hit a new 52-week low today.

On the other hand, Rentech converts coal into oil products like diesel and jet fuel, and can do so at the equivalent of $35 a barrel oil. It is a very different business. Buy RTK up to $5 for my $11 target. 

Video iPod MegaShift

This MegaShift is getting very interesting. Apple’s stock is getting clobbered because analysts are cutting estimates due to soft iPod sales. Apple hasn’t introduced a new iPod in more than nine months, and you know why. The Burst.com patents I told you about, followed by the lawsuits between the two companies, mean Apple can’t introduce the next video iPod until the issue is settled. I have no idea why Steve Jobs is being so stubborn over this, as he could just buy Burst.com and get his money back licensing their technology to others.

(By the way, I know you are being urged by others to buy Apple right now. Don’t do it yet. I know this will sound far-fetched, but Sarbanes-Oxley is a rough piece of legislation on any director that still thinks the good ol’ boy network runs Corporate America. Steve Jobs is caught in the options backdating scandal, and there’s a real chance the Board will have to remove him as Chief Executive Officer. That would devastate the stock, and it’s just not worth the risk when we are facing 90 more days of a bear market.)

One of the “others” Burst.com already licensed is Microsoft, for a cool $60 million. And now we know why. The jungle drums are very strong that Microsoft will introduce a music player and a music service before the holiday season to compete with Apple’s iPod and iTunes. The digital player will have a Wi-Fi Internet connection, so owners can download songs without being connected to their computer.

Apple has 77% of the $4 billion U.S. market for digital music players, with SanDisk second at less than 10%. iTunes has 72% of the music download market, and Microsoft’s Music Store has 3%. After six years of trying, Microsoft has decided it can’t rely on SanDisk, Creative Technology or any of the other companies that use its software to make any meaningful challenge to Apple’s dominance. They had high hopes for Samsung, but that company now is supplying the semiconductors for some of Apple’s upcoming iPods. So, it hired some heavyweight music executives and committed to doing the job itself.  There is a very good chance Microsoft will use PortalPlayer (PLAY) as the supplier for the audio and integrated video chipset. The Microsoft player is said to have a much better video screen than the video iPod, so PortalPlayer’s higher quality technology would really shine.

Of course, Apple needs to introduce new models by October in order to have a decent holiday sales season, and I still think one will be a much more advanced video iPod also based on PortalPlayer’s integrated chipset. Right now, I’m looking for an opportunity to double down on PortalPlayer, so be ready for a Flash Alert when it is time to move..

One of the really tantalizing questions is whether Microvision (MVIS) will get a screen contract on a high-end Microsoft product, or on a competing Apple product. Bill Gates has publicly said that he loves the Microvision technology. Recently, Microvision has not only slipped below $2 to a new 52-week low, but it also now has a warrant that started trading on May 31 (MVISW).This warrant could become very attractive in a market meltdown. If and when the time comes, I will send you a Flash Alert to jump back into MVIS and pick up MVISW.

You may be wondering why I’m not suggesting that we buy Microsoft. I’m not making this a recommendation for the same reason I didn’t recommend Apple — we’ll make more money on the parts suppliers than the audio player manufacturer. Plus, Microsoft has one more shoe to drop when they delay Windows Vista and Office 2007 again.

WiMAX MegaShift

Craig McCaw, the cellular telephone pioneer and billionaire, just closed the biggest venture capital round ever — $900 million, led by Intel Capital, which put in $600 million. It was the largest investment ever by Intel Capital. Motorola invested, too.

Is WiMAX real, or what? McCaw had planned a $400 million IPO for Clearwire Corp., his WiMAX network startup. He took the venture route instead.

Sean Maloney, the Intel executive VP and general manager who often talks to us at the Intel Developers Conferences, said: “Wi-Fi has become an essential part of people’s lives. WiMax is next. It is rapidly moving from a technology initiative to real deployments. This investment in Clearwire will lay the foundation for high-speed mobile broadband services across North America.”

Intel also announced a dual-mode WiMAX chip that supports both the fixed and mobile WiMAX technology standards, and unveiled the newest version of their Rosedale WiMAX chip for residential modems. All three WiMAX equipment stocks — Alvarion (ALVR), Airspan (AIRN) and Terabeam (TRBM) are now Top Buys.

MobilePro (MOBL) restructured their convertible debt with Cornell Capital Partners (see the Plug Power write-up above for more about an SEC investigation of Cornell) in what I think is a dangerous way, so I am moving the stock to a Hold.

This is a $15 million convertible with a 7.75% coupon, issued in May 2005. MobilePro now has the right to make payments in either cash or stock, which management positioned as a positive. However, beginning September 1, they agreed to make weekly principal payments of $250,000, plus interest. I estimate that at the end of June they had about $2 million in cash, so I would expect them to make many or most of these payments in stock.

The stock that is used for payment will be valued at 27.5 cents a share or the average of the two lowest volume-weighted average daily prices during the five days before the payment, whichever is less. That gives Cornell Capital an incentive to short the stock, drive it even lower, take more and more shares every week, which drives it lower yet, and eventually take the company away from the current shareholders. That’s very similar to what the SEC is investigating Cornell for already. I thought managements had gotten hip to these toxic convertibles, but apparently not. Cornell Capital now beneficially owns about 5% of MOBL stock and does not have a board seat, so it will be difficult to tag them with negotiating an insider, sweetheart deal that hurt the other shareholders. But maybe the SEC investigation will cause them to behave.

Why not sell right away? Because in the exact same situation with Corvis a couple of years ago, I did recommend selling right away. Management of Corvis found cash elsewhere, made the convertible payments in cash, and the stock doubled. The other terms on this restructuring are more onerous than in the Corvis case, but they primarily relate to redemption.

MobilePro might be able to make these payments out of cash flow. For example, this week they signed a deal with FSH Communications for local exchange services that should generate about $12 million in revenues a year. MOBL also has numerous operations and assets that could be sold to raise cash to make these payments, so I don’t want to cut and run at this point. But until we see the other shoe drop — management’s plan to avoid making these payments in stock — we can’t continue to buy it. Hold MOBL. I am also suspending the target price until we get more information on management’s plans.

Market Outlook: Testing the Limits

The Fed is like a two-year-old child that keeps pushing and prying until something breaks — the bond market, the stock market, the real estate market, the commodities market or the economy. All they had to do was hint at an interest-rate pause at the July meeting, and commodities rallied in a shot. That is not what they wanted to see. Fed Vice-Chairman Donald Kohn gave a speech to the British House of Commons in which he said: “I think we are very well aware in the Fed that there is some risk that we would tighten policy more than necessary and that it might induce weakness in the economy… [but] there is a greater risk from not tightening.”

The big difference between the Greenspan and Bernanke Fed is going to be published inflation targets. This is Bernanke’s pet project, and I identified it as the most important issue as he was being confirmed. It is the same policy the European Union follows, and I call that evidence that it is a failed policy.

The Fed should be looking at leading indicators to have a hope of coming up with the right policy, because their interest rate changes don’t impact the economy for six to 18 months — inflation is a lagging indicator. By publishing an inflation target, they are locking themselves in to letting a lagging indicator determine monetary policy, which itself will have a lagged effect on the economy. In periods of slowing economic growth, like now, inflation stays high for a while and will prevent the Fed from acting quickly enough to reverse course. But if you think this is bad, wait until you see what happens coming out of a recession, when the Fed keeps pouring on the coal as the economy accelerates, because the printed inflation numbers are still benign from the recession. We’re entering a much more volatile world than today’s VIX Index (the volatility index) would lead you to believe.

Bernanke’s strength was just solidified by President Bush’s most recent nominee to the Fed, Fred Mishkin. He is the co-author of Bernanke’s economics textbook, which goes on at length about the importance of central bank policy targeting inflation, with published upper and lower bands of what inflation should be.

They may also change the preferred measure of inflation, from Greenspan’s Personal Consumption Expenditures to the Bureau of Labor Statistics’ “harmonized” inflation, which is calculated the way the European Central Bank does it. Most people don’t know that the rest of the world calculates inflation differently, which is one of the biggest reasons European real GDP growth has seemed so much lower than the U.S. growth for the past few years.

They also don’t know that the Personal Consumptions Expenditure deflator excluding food and energy — so-called “core inflation” in the U.S. — gives the lowest possible picture of inflation. Both the PCE and the Consumer Price Index have been very tame, while “harmonized” inflation has been booming along in a way most people who actually buy things can relate to. It has become a joke that our government reports very low inflation, while the prices of goods and services are jumping. But the Fed is not laughing — they know the “harmonized” numbers show a major problem, and that may be a main reason they sound so hawkish on inflation.

Given this data, there are two likely scenarios: Either the economy is going to slow sharply enough to bring inflation down, or the Fed is going to keep raising rates until something breaks and forces the economy to slow. Neither scenario is good for the bullish case. I continue to think that the S&P 500 has a date with destiny at 1185 in the near future, and 1040 or worse in October. From current levels, that’s a 5% drop followed by another 12% decline. The best way to preserve and grow your money in this environment is to continue to hold a comfortable amount of cash, and if you are underinvested, focus on the energy technology stocks first.

In last week’s Radar Report, I mentioned that this is a great time to move some money into the New Energy Technology MegaShift, before the hurricane season moves oil prices up even higher. Although I am still expecting the broad market to resume its slide to an October low, I also expect the energy stocks to be substantially higher by then as it becomes more and more obvious that energy prices will remain sky-high for the next several years. Analysts have had to raise their forecast for the average price of oil in 2006 by more than $9 a barrel so far this year, and that was before this week’s new oil price records of over $75 a barrel.

The cost of energy is so high right now that alternatives are no longer an environmentalist wish, but a global need. And as I’ve noted before, technology offers many alternatives in the energy area. Last week, I said some things I want to repeat with emphasis added, because they are so important to your financial future. In my lead-in to the Rentech recommendation, under the heading “It’s Not About Energy; It’s About Energy Technology,” I said:

“There is a huge amount of energy available in the world. Some of it is in the form of millions of years of sunlight stored as oil, gas, coal and wood. Some of that is easily available in the form of trees to cut, or pools of oil less than a mile below the surface of the earth to tap. Some is a little harder to get to, perhaps it lies two or three miles under the ocean. Some of it is even harder to extract because it is locked up in tar sands or oil shale. Energy is also stored in the form of uranium deposits, hydrogen in water, oil in whales and heat from the core of the earth.

In addition to the stored energy, every day brings more solar energy, wind energy and wave energy that can be tapped directly. So, we are not about to run out of energy. The “energy crisis” is about the cost of energy, not the lack of energy. And the solution to high prices for oil is high prices for oil. That is, high prices for oil promote conservation and the development of alternative energy sources that didn’t make economic sense in a world of $20 or $30 oil, but in a world of $50, $60 or $70 oil, they show great rates of return. Those rates of return are built on better technology — more efficient solar panels, ethanol from cheap cellulose feedstocks, biobutanol from sugar beets, steam-assisted gravity drainage to get oil out of tar sands, pebble-bed nuclear reactors, heat-assisted liquefaction of kerogen in oil shale, carbon-fiber windmill blades and bidirectional module drilling to tap the 65% of conventional reserves left behind by an ordinary oil well.

My job is to find and analyze the best of these technologies, calculate realistic costs of production from the various alternatives, identify the best companies applying each technology, and then wait for their stocks to fall to low-risk, high-return entry points."

I don’t just sit in my office googling alternative energy to find these companies; I put these technologies to the test. I had a 4200 watt solar system intertied to the utility grid with four days of battery backup at my ranch in Half Moon Bay, and I did a wind analysis before deciding not to put up windmills on my highest hill. And recently, I got some good current numbers on the real costs of various forms of solar, wind and wave energy. The findings were one factor in today’s new recommendation:

Technology Comparison

	Fossil Fuel	Solar	Onshore Wind	Offshore Wind	Ocean Waves
Energy Density	Very High	Low	Low	Moderate	High
Predictability	High	Unpredictable except in some sites	Low except in some sites	Moderate	High
Load Factor	50%–90%	10%–20%	25%–35%	25%–35%	30%–45%
Visual Impact	Very High	Can be Unobtrusive	Moderate	Low	Minimal
Potential Sites	Extensive, but permitting process can be lengthy	Limited for High Energy Density; Extensive for low to Moderate Density	Limited	Limited in US; Moderate in Europe	Extensive on Coastline
Cost* Per Kilowatt Hour — Remote Power	N/A, needs refueling	25–50¢	9–10¢	16¢	7–10¢
Cost* Per Kilowatt Hour — Utility Power	4¢	10–25¢	4–5¢	7–9¢	3–4¢

*These costs assume high production volume. Subsidies, credits and grants will further reduce costs.

Look at the bottom row for the crucial information on cost per kilowatt hour. Fossil fuel plants, for all their high raw material cost and pollution problems, produce electricity at a cost of only four cents per kilowatt hour. That’s because the energy density of oil is so high, but picking a plant site, permitting and pollution problems are extensive.  

Solar costs multiples of that, 10 cents to 25 cents per kilowatt hour before subsidies. (The state of California will pay up to $2,000 for new residential solar units. I think they pay about 25% of the total cost — closer to $8K.) It doesn’t work if the sun doesn’t shine, so night time, winter and rainy days cut production sharply. Putting a big solar array in the desert gets the costs down toward the low end of the range.

Onshore wind power — a windmill — costs only four or five cents a kilowatt hour, but they produce power unpredictably in most sites, only make sense in a few places, and can be very visible and dangerous to birds. I often drive through the Altamont Pass, east of the Bay Area, which is loaded with commercial windmills. Usually, only one out of five or 10 is working, and that’s in what most people call a high wind area.

Offshore wind power benefits from more reliable wind, but there still can be visual and environmental issues, and the cost of building a windmill offshore makes the cost per kilowatt hour about double that of fossil fuels.

Change Waves Into Electricity

Now look at wave power, which is basically a highly modified buoy bobbing up and down in the ocean. The cost per kilowatt hour is directly competitive with fossil fuels, because the energy density of waves is high, about 1000X denser than wind. Wave energy is the most concentrated form of renewable energy. It costs about $1.2 million to build the equipment and infrastructure for a megawatt of onshore wind power, compared to just under $1 million for wave power. Plus, energy production is predictable because thanks to decades of Navy research, wave action can be accurately forecast days in advance of them hitting the buoy.

To understand how wave power works, let’s take a look at how waves are created and how they are a form of energy. Waves are created by wind, and wind is created by differences in temperature as the sun heats the earth’s atmosphere. As wind flows over water, energy is exchanged between the wind and the water’s surface. At first, little ripples appear on the surface, like those on a pond. Then, the wind that skims along these ripples causes higher air pressure at the front of the wave than at the back, and the ripples change into small waves. There isn’t enough room on a pond for this to happen, but there’s a bit more on a decent-sized lake, and plenty of room for big waves on the Great Lakes.

As this process continues, the waves become higher and the distance between the tops — the wave length — becomes longer. The amount of converted energy depends on the wind speed, the time the wind blows over the waves, and the distance it covers. As a wave travels, it takes on the shape of a regular wave or swell. By the time these hit an ocean shore, the swells are very regular and easy to see, even when the sea is relatively calm.

So, wave energy really is a concentrated form of solar energy, and during the process of conversion, energy is concentrated up to a power level of over 100 kilowatts (kW) per meter of wave front. There are many ideal locations in Europe, North and South America, Africa, the South Pacific Ocean and Asia where high power densities exist close to highly populated areas. The map below shows power densities in kilowatts per meter of wave front. Anything over 20 kilowatts per meter is a potentially harvestable site. According to the World Energy Council, wave power could potentially provide two trillion watts of energy, double the entire world’s current consumption of electricity.

A wave energy converter turns the mechanical energy of a wave into low-cost, clean electrical power. It is a buoy, mostly below the surface of the ocean, anchored one to three miles offshore — far enough that, in contrast to offshore wind farms, they usually are not visible. And there are no environmental problems; on the contrary, the anchor chains make great artificial reefs for ocean life.

As the buoy rises and falls with the waves, a piston inside drives a generator, which produces electricity. That can be used on-site to power, for example, navigation lights or a radio transmitter, or sent to shore through an underwater cable. Like solar and wind, there is no fuel, no exhaust gases or other particulate pollution, no waste water or solid waste, and, unlike wind power, no noise.

Computers control the systems that capture, convert and transmit wave energy electricity, and an array of buoys networked to an underwater cable is a wave generator power plant.  Sensors continuously monitor the performance of the bouy’s systems and the surrounding ocean environment, and transmit data to shore. A buoy stops producing power when it senses very large incoming waves, in order to avoid mechanical failure. When wave heights return to normal, the buoy restarts energy conversion and transmission of electrical power. Most of the time, wave power is predictable and dependable.

Catch This Wave

Ocean Power Technologies (OPT LN) has spent the last 12 years and nearly $30 million developing the heavily patented PowerBuoy, which is now being deployed in projects in several oceans. They are anchored in 100 feet to 150 feet of water, with a few of the buoys in each array carrying radar reflectors and warning lights on masts for marine navigation.

OPT patents cover system design, power conversion, control systems and wave farm architecture. Even their anchoring and mooring system is patented, as it avoids any environmental damage to the seabed or ocean life. Projects are planned to have zero negative environmental effects. There is no significant restriction on swimming or fishing, and the buoys probably increase sea life in their immediate area due to the artificial reef effect. Power flows to the shore through a standard submarine cable, running inside a conduit through the surf zone. There is no negative impact on the shoreline, and a wave energy absorber may even reduce shoreline erosion. I suppose surfers might object to smaller waves off their favorite beaches, but it’s easy to simply not deploy systems there.

A 10-megawatt power station of multiple PowerBuoys occupies only about 30 acres of ocean space — roughly 30 football fields — and the technology is scalable to at least 100-megawatt stations. Within a power station area, buoys are spaced to maximize energy capture. The steel buoys and power cables are simple to construct and install, using existing boats and marine infrastructure.

Beginning in 1997, OPT spent several years in ocean trials, testing versions of PowerBuoy systems off the coast of Atlantic City in a program partly funded by the U. S. Navy. The Navy is the largest U.S. government consumer of energy. In 2004, OPT installed the first 40 kilowatt-rated PowerBuoy under a contract from the Navy for a wave farm off the Marine Corps base at Kaneohe Bay on Oahu.

This required a rigorous environmental impact assessment by the Office of Naval Research, in consultation with the National Marine Fisheries Service and U.S. Fish and Wildlife Service. Their finding: “No Significant Environmental Impact.” The company can use this report to open discussions on the features, safety and benefits of the PowerBuoy system for other projects, and expects to be proactive with local residents, commercial fishermen, environmental protection groups and other stakeholders.

In 2004, they also completed permits for a project in Australia and entered a joint venture with Iberdrola S.A. to build a wave farm off the north coast of Spain. Iberdrola is Europe’s largest utility in renewable energy, with over $13 billion in annual revenues. The Spanish government says that it expects to install hundreds of megawatts of wave power off the country’s coast.

In 2005, OPT signed an agreement with Total S.A. of France to develop a two- to five-megawatt wave power station off the west coast of France. Total is one of the largest oil and gas companies in the world. They also installed a 40 kilowatt PowerBuoy off New Jersey under the New Jersey Board of Public Utilities’ Renewable Energy and Economic Development program. That system rode through the wave and wind forces of Hurricane Wilma in fine shape.

This year, OPT begin the first phase of a 1.25 megawatt wave farm off the northern coast of Spain, via the joint venture with Iberdrola. Ocean Power was also one of three companies that won contracts for a full-size demonstration plant of up to 10 megawatts capacity, 10 miles off Cornwall in UK waters, connected to the national electrical grid. This South West Wave Hub Project will be planned this year and built beginning in 2007.

Ocean Power also received a contract from the Department of Homeland Security to work with Lockheed-Martin on a network of acoustic sensors and communications gear to detect and track ocean-going vessels, all powered by autonomous PowerBuoys, not hooked to a grid.

I expect the next contract to be for a demonstration system, followed by the big contract for deployment of the whole system. The same technology could find applications in ocean research, tsunami warnings, desalination plants or even ocean-based fish farms.

London Calling

Although Ocean Power Technologies is located in New Jersey, it went public on the London Stock Exchange’s AIM market in October 2003. Companies do this to avoid the costs and legal exposure of Sarbanes-Oxley — thank you Senator Sarbanes, for driving New World technology companies away from the NASDAQ. Most brokers can trade on the London market, so this should not be a problem for you. There is a U.S. version, OPWT, which trades very infrequently on the pink sheets (OPWT.PK). It is usually priced well above the London shares, so I only recommend it if you are very tough on your trading limits and plan to hold the stock for a long time.

OPT has an April fiscal year and reports every six months under British rules. The company’s losses jumped from around $1 million every six months to $4 million in the six months ended October, and probably another $4 million in the six months ended April. But those losses will diminish as deferred contract awards come through, and I expect them to lose $4 million for the entire current April 2007 fiscal year and then $2 million in the April 2008 period. When they report April 2006 fiscal year results (probably not until October), they will have about $31 million in cash on the balance sheet as of the end of April, with virtually no debt, so they have more than enough cash to see them through to profitability. They won’t own the wave farms, but they will make good money building them, and then recurring revenues operating and servicing them.

OPT has a total market capitalization of only $70 million. The stock closed today at 72 British cents, which equals $1.32. (To convert, multiply the price in British cents by 1.84.) Obviously, wave power is a very early stage technology, but I think it has tremendous natural advantages over solar and wind for a utility near the ocean, and Ocean Power is the technology leader. I expect them to demonstrate their superior technology in the Wave Hub Project, where they will be in a bake-off with two other companies.

Could this be a 10-bagger — 10X on your money? Absolutely. If their technology works as well as it appears to, the contracts keep coming and the installations work, it’s hard to see how they could not be a 10-bagger. The company’s UK-based head of European operations said that he thinks OPT will be a billion-dollar company someday. That’s a 14-bagger. Buy OPT on the London Stock Exchange up to 82 British cents, or roughly $1.50, for a double by this time next year.

Do not put your whole IRA into any development stage situation, including this one. But it should find a place in your New Energy Technology stock portfolio, where we now have:

• Steam-assisted gravity drainage of Canadian tar sands — Connacher Oil & Gas (T.CLL)
• In situ heating of Colorado oil shale — Royal Dutch (RDS.A), Gasco (GSX) and Infinity Energy (IFNY)
• Conversion of coal to oil — Rentech (RTK)
• Refining heavy, sour crude and tar sands — Holly Corp. (HOC)
• Wave power — Ocean Power Technology (OPT)
• Hydrogen fuel cells — Fuel Cell Energy (FCEL) and Plug Power (PLUG)

In addition, I’m still looking for a solar company that makes sense in an era of silicon shortages, and waiting for a good re-entry point for Energy Conversion Devices (ENER). One of my favorite sailing quotes is also appropriate for investing in energy technology:

“The winds and the waves are always on the side of the ablest navigators.”
– Edward Gibbon

New Energy Technology MegaShift

FuelCell Energy (FCEL) developed a spin-off technology to separate pure hydrogen from a gas mixture, which then can be sold as fuel for hydrogen vehicles or industrial uses. The Department of Defense just gave FCEL a $1.36 million contract to advance this Electrochemical Hydrogen Separator project for use with FuelCell’s power plants. FCEL remains a buy up to $11 for my $22 target.

Rentech (RTK) got a favorable write-up in yesterday’s New York Times. The story pointed out that the biggest problem with coal-to-oil is that the process generates so much carbon dioxide, and that most projects focused on coal (in South Africa and China) have no incentive to capture the carbon dioxide beyond the small amount that can be sold as an industrial gas. Then the Times mentioned Rentech as the one company focused on solving this problem. I had a related question on this from Patti: “I noticed your selection of RTK this month and was wondering how their process compares to Sasol (SSL). SSL seems to have experience in this industry with production in South Africa as well as new alliances which will bring them online in other emerging markets, and a well-established connection to big oil.”

All true, Patti, and Sasol probably can produce oil cheaper than Rentech’s roughly $35 present cost. But the big difference between the two is this pollution issue, and there is just no way that U.S. coal is going to get converted using a process that doesn’t deal with carbon dioxide. I mentioned in last week’s recommendation that a Chinese company has squeezed their cost of production down to $23 a barrel, but I really wonder if the Chinese government is going to let them build any significant number of plants unless they license the Rentech technology.

In any event, our Rentech investment is going to work based on U.S. coal. If other governments or developing countries start to care about carbon dioxide pollution, RTK may be competitive with SSL in building systems in developing countries. But that would just be icing on the cake. Buy RTK up to $5 for my $11 short-term target, and congratulations on getting the stock to trade 10X normal volume last Friday without running it up! We have collectively taken about four million shares away from the market makers while hardly budging the stock. Continue to use limit orders.

Avian Flu MegaShift

The World Bank estimated that a severe bird flu pandemic could kill 70 million people, cost the world up to $2 trillion and stop economic growth for a couple of years, beginning with a 3.1% decline in world GDP. It would also bankrupt the airline industry and numerous hotels and restaurants, collapse the price of commodities, break Medicare and put our three MegaShift stocks through the ceiling.

With almost 3X as many deaths from bird flu in the first six months of 2006 compared to 2005, Asian poultry farmers have already suffered about $10 billion in losses. Everyone agrees that the immediate key to avoiding a pandemic is controlling outbreaks in birds in Indonesia and the eight countries in Africa that have been infected this year. Unfortunately, those countries have little money and less infrastructure to do the job, and most can’t even detect and report cases of infection on a timely basis. When a country doesn’t have veterinarians, laboratories, vaccine stocks or the money to compensate farmers, talking about avoiding a pandemic looks like a stretch.

The virus already mutated substantially. It used to cause lesions in the digestive tract, and now the most prolific replication and severe lesions are found in the brains and hearts of infected birds. The head of virology at the Oxford University Clinical Research Unit in Ho Chi Minh City said that H5N1 is increasing its ability to cause respiratory illness in humans.

Our government is asking vaccine makers to expand or build new plants, but they’ve requested proposals for chicken egg production instead of the cell line production developed by Top Buy Crucell (CRXL). That’s a major tactical error, because it means that it will take six months to develop a vaccine after the mutation causing a pandemic is identified, and then another six-month delay every time a new mutation occurs.  H5N1 mutates very quickly, and it is hard to believe Health and Human Services Secretary Michael Leavitt could make such a basic error. He is telling businesses to plan to operate without 40% of their workers for the first six months, because the government is going to close the schools and some parents will have to stay home with their kids. What he isn’t saying is that these six-month periods will recur over and over until the pandemic runs its course, because he has blessed the wrong technology for making vaccines. Of course, like the bureaucrats that created the food pyramid based on a high-carbohydrate diet and now wring their hands about obese Americans, he will never be held to account for his mistakes.

He may even be saved by the free market. Baxter International just started human testing of a new bird flu vaccine using cell-based technology, and it can respond to a new strain of H5N1 in 11 weeks. Phase I results will be available this fall, but the company already has an order from the UK for two million doses based on the cell technology.

Remember that vaccines are different from the antiviral medicines that underlie our investments in Gilead (GILD) and BioCryst (BCRX), both of which remain Top Buys.

Biotech MegaShift

Geron (GERN) had some remarkable presentations at this week’s annual meeting of the International Society for Stem Cell Research. They showed stem cell data for acute spinal cord injury that succeeded in re-growing some nerve functions. They also produced very pure islet clusters to produce insulin, for eventual testing in diabetics. Other projects included stem cells to repair the damage from heart attacks, bone fractures and osteoporosis. Some very early work covered liver failure and drug metabolism testing.

Geron is well ahead of other stem cell companies, and even though Wall Street has little interest in a development-stage biotech right now, this may be the best baby they are throwing out with the bath water. Buy GERN up to $9, looking for a trade to $18 on further announcements and news stories.

QLT (QLTI) scheduled their earnings call for July 27, before the market opens, with no negative preannouncement. Last Friday, Genentech got FDA approval for Lucentis to treat all forms of wet macular degeneration. Lucentis is given by an injection in the eyeball, and acts to block the growth of blood vessels. Genentech’s Avastin cancer drug, which is much cheaper than Lucentis and has the same mechanism of action, is being used off-label for macular degeneration. Macugen also blocks blood vessel growth, and is approved for macular degeneration.

Looking at all three of these similar drugs, I expect Lucentis to get about 85% of the blood vessel blocking market in spite of its high price, because it is approved for this indication and will be reimbursed. Avastin may get 10%, and Macugen 5%.

So where does that leave QLT’s Visudyne? The price of QLT says they’re out of it, yet the stock closed higher today than last Thursday, just before Lucentis was approved, and it is back over my $7 limit. The bad news is out, and I think the pendulum is about to swing rather sharply. Visudyne works through a different mechanism of action, does not need to be injected into the eyeball, and is easily used in combination therapy with Lucentis, Avastin or Macugen. There are studies underway to support this approach Because Wet AMD is the leading cause of blindness in people over the age of 55, stopping people from going blind is a high priority with no room for half-measures. I expect Visudyne sales to not only stay high, but grow — confounding Wall Street and making us a good deal of money. The company may say more about this on their conference call. Buy QLTI under $7 for my $20 target.

Content on Demand MegaShift

Telkonet (TKO) still has not received the formal approval letter from the government that will let them announce the EDS contracts. I don’t think that they know why it is taking so long, other than it’s the Federal bureaucracy in the summer. The last hearing gave them verbal acceptance, and there are no more materials to be submitted. I know from your many emails that it is painful to wait. Gregg asked: “When can we expect these TKO announcements that you keep telling us are coming? Are you sure that this CFO situation won’t bite us?”

The announcements are overdue and could come any day. As for the CFO situation, there are always a lot of good CFO candidates around, so it won’t be a long-term problem. Short-term, the CEO has postponed his prostate surgery (and I sent him some info on alternative approaches that may persuade him to cancel it) in order to negotiate the strategic investment that is underway.

Of course, uncertainty hurts small stocks in down markets, and Todd wrote: “Short interest is climbing. Is there something that you have not uncovered? The stock is down roughly 20% in the last 45 days. Please respond accordingly.”

Todd, short interest was around 5.0 million shares for five months, and then moved to 5.6 million in April as the company began looking for an investor. The hedge funds often short stocks in these situations, usually in hopes whoever is going to do the deal will also short the stock to drive the price down. Short interest went to 5.7 million shares in May. But the company has made it clear that they are looking for a strategic investment, and that kind of money doesn’t play hedge fund games. Short interest fell a bit to 5.5 million in June. I don’t think this is an indication of anything other than a deal that has not been announced.

David asked: “Is there a danger of another disaster with Telkonet? How sure are you that they will get their financing; and what happens if they don’t? I wanted to be informed of the dangers.”

It’s always possible a financing won’t close — for example, another domestic terrorist attack would probably shut the financial markets and cause any deal to be put on hold. TKO could run out of money, in which case they would have to sell parts of the company, or the whole thing. I believe the Microwave Satellite Technologies subsidiary in New York City could be sold for $10 million to $20 million, without impacting the future of their broadband-over-powerline business one bit.

Finally, Jim asked: “Is your $15 target by year’s end based on the EDS contract only, or is there something else on the horizon? A 5-banger from here seems to be a stretch and I, like many I suspect, have a significant investment in TKO based on your numbers.”

Jim, my target is based on many new orders for broadband-over-powerline, including the EDS contract. After the company secures financing and announces the name of the strategic partner, which I expect to add dollars to the price of the stock, they need to show order and revenue momentum to get Wall Street excited. This is a multi-billion dollar opportunity, and a market capitalization of $1 billion isn’t that much for a company deploying products in a brand-new, fast-growing technology. Buy TKO up to $5 for my $15 target.

Zhone Technologies (ZHNE) filed an 8-K last Friday that got lost in the holiday weekend. It revealed that the Compensation Committee gave a $435,000 discretionary cash bonus to Mory Ejabat, the CEO, for “recent successful achievement of business goals and other factors.” That sounds like some good announcements might be coming, including beating the breakeven consensus estimate for the June quarter. They said yesterday that they will report on July 20, and there was no negative preannouncement.

My old friend Dick Kramlich and his New Enterprise Associates bought 300,000 more shares of ZHNE in June at $1.91. The company is seeing growing sales of its next generation Single Line Multi-Service products, while the bottom line is benefiting from cost savings after the acquisition of Paradyne last year. As the cable companies transition their networks from proprietary copper to Internet Protocol optical fiber, and the telephone companies give up on their circuit-switched copper for packet-switched Internet Protocol copper and fiber, huge amounts of money are being spent on the upgrades. Zhone and Paradyne are trusted suppliers to these customers.

Zhone has $70 million in cash, and the company should be profitable this quarter and from here on. I’m looking for 5 cents a share for 2006 and 15 cents to 20 cents in 2007. I’m going to keep ZHNE as a Top Buy, trim the buy limit to $3 and keep the target price at $7 for this year, which is a terrific return from current levels.

Security MegaShift

Gemplus (GEMP) has changed its name to Gemalto, following the merger of Gemplus and Axalto last month. They will delay filing a financial report with the SEC because the French authorities have asked the company’s auditors to review disclosures on forward-looking statements. The auditors couldn’t complete their work by the June 30 deadline, but the company does expect to file shortly. This should not affect the stock.

GEMP won a 10-year contract to provide a million electronic passports to Slovenia, just one of many they have booked. Buy GEMP under $6 for my $12 target.

WiMAX MegaShift

Seven bidders filed wireless Internet plans to cover 1,500 square miles of Silicon Valley, from South San Francisco to Santa Cruz. MetroFi, which has already built networks in other parts of the Bay Area, bid a network similar to those it already operates in Cupertino, Santa Clara and Sunnyvale, where it offers free service with ads or a $20-per-month subscription without ads. Both have download speeds of 1 megabit per second, roughly equivalent to DSL service.

Cisco Systems is partnered in two different bids, one with VeriLAN, an Oregon-based wireless network company that wants to own the network but lease it to others to offer the ISP service, and the other with IBM and SeaKay, a San Francisco nonprofit.

Other bids came from the Blue Horizon Group in San Francisco, Community Wireless in Palo Alto, Fire2Wire in Carmel and NextWLAN in Los Gatos. EarthLink and Google, which are building the municipal wireless Internet network in San Francisco, and MobilePro (MOBL) did not submit proposals.

The winner will be announced on September 12. There are about 250 municipalities across the United States that have built or are planning WiFi networks, which leaves plenty of opportunity for MobilePro without taking on a bite this big. One of the basic issues is whether the network will be free, supported by advertising, or paid, or both, like MetroFi’s service. When Sacramento officials flip-flopped on this issue, their deal with MobilePro fell apart.

I’ll have more comments on MobilePro’s recent lease financing announcement next week, after I talk to some industry contacts, and answer a couple of subscriber questions. Continue to buy MOBL up to 30 cents a share for my 70 cent target.

Market Outlook: Incoming!

Many years ago, a friend who had been on the front lines in Vietnam screwed up his courage to go see Apocalypse Now. The movie opened with a slow pan of quiet, pastoral rice fields. After a few seconds of this, he screamed: “Incoming!” and dove under his seat. His date and the rest of the folks in the theatre barely had time to react when the screen erupted in mortar and rocket attacks.

Thirteen months in Vietnam trained him to react to the slightest clues and nuances that things were about to go wrong, and three years back in the States hadn’t dulled that survival reaction one bit. The filmmakers put in a flash of light that I can barely see, even though I’m looking for it, but that was all he needed to make the move that had kept him alive while others died.

Last week, when the Fed repeated that “incoming information” would determine whether further increases are needed to keep inflation in check, I thought about my friend. I always put their new statement next to their prior statement and use yellow highlighting to see the real differences. While Wall Street focused on their phrase that “moderation in the growth of aggregate demand should help to limit inflation pressures over time,” I saw a few other things, bolded below:

Last Month

“As yet, the run-up in the prices of energy and other commodities appears to have had only a modest effect on core inflation.”
This Month
“Readings on core inflation have been elevated in recent months.”

Last Month

“Still, possible increases in resource utilization, in combination with the elevated prices of energy and other commodities, have the potential to add to inflation pressures.”
This Month
“However, the high levels of resource utilization, and of the prices of energy and other commodities have the potential to sustain inflation pressures.”

It looks to me like the Fed is saying that core inflation is too high due to the prices of energy and other commodities, and they also are worried about “resource utilization,” which is Fedspeak for tight employment and job growth. The combination of these could sustain high inflation for a while, preventing them from lowering rates. If they see lower energy and commodity prices, and if the labor markets loosen up, and if the core inflation rate comes down, then that “incoming information” might give them some space to at least pause.

That’s pretty thin stuff to sustain a huge rally. Sentiment got so negative that anything short of an asteroid headed for the earth probably could have set off this round of short-covering and buying back puts. However, while it is possible we will get lower energy prices going through the hurricane season, even with Iran refusing to play President Bush’s deadline game, that’s not the way to bet.

As for lower commodity prices, the Fed’s dovish statement set off a furious rally in the very commodities markets the Fed wants to see fall. If the Fed hadn’t been so dovish, Mr. Market might have done the Fed’s work for it by blowing out the hedge fund speculators and driving commodity prices in the desired downward direction. But by being so eager to make market-pleasing comments, the Fed made their real job even harder.

Tomorrow’s labor market numbers, manipulated as they are, will be important. Any change in nonfarm payrolls smaller than about +120,000 should push both the bond market and the stock market up, while anything near or over +190,000 could set off a nasty decline down to the 1185 level on the S&P 500.

But the Fed’s biggest problem is with core inflation. We have been in a very unusual period in which headline inflation has been quite high due to energy prices, but core inflation (ex-food and energy) much lower. Spreads this wide usually don’t sustain themselves for so long, and the trend on headline inflation is accelerating. Core inflation has been flat, at or just above the high end of the Fed’s tolerance range. If the core numbers start to chase the headline numbers higher, because energy prices diffuse into many other products and, eventually, into wages, the Fed will have no choice but to accelerate the funds rate increases to half a point each time and stop talking about moderation.

Unfortunately, the most likely path for core inflation is precisely that: Up. So, I continue to be cautious about anything other than a contrarian sentiment rally, and still think there are much lower prices coming for the broad market in September and October. Cash is still a good idea.