As we enter 2007, remember that this is the beginning of the “Time of Troubles” when an antichrist will rise up and World War III will begin. So said Nostradamus, the 16th century astrologer, who regularly violated the First Law of Successful Forecasting: Never Give Them Both A Prediction and A Date. I’m going to violate the same law today, because that is what you pay me to do. But I must say that I’m glad I only have to look ahead 12 months instead of four or five hundred years.

Though I don’t see worldwide pandemonium in the cards, I do see some specific life-changing forces developing that will drive our MegaShifts to the next level. Last week, I covered the outlook for the Avian Flu and Biotech MegaShifts — both quite positive for 2007. This week, in Part II of my outlook for 2007, we’ll cover the more technology-based MegaShifts.

China MegaShift

There are three major areas to watch in China in 2007: the economy, telecommunications and currency. We’ve made some money in a few of these areas in 2006, and we’ll be looking to return to some of these companies as well as invest in few new ones. For now, I want you to get up to speed on the major drivers of China’s growth.

We all know about the explosive growth in China, and we all know that is not sustainable. That’s why the first major factor that we’ll be watching is a slow down in China’s growth. But in this case that is a good idea. The Chinese government is determined to slow things down, because they don’t want high inflation to cause unhappiness among the populace, and a more stable growth path will make it easier for businesses to function without resource shortages. Their financial and persuasive pressures, so far, have slowed construction and infrastructure spending, except for the showplace projects for the 2008 Summer Olympics. If their recent efforts work, they’ll ease off the brakes and the economy will grow at a more reasonable pace.

A natural slowdown in the economy will also relieve some strain in their raw materials and energy areas, where things got quite out of balance during the roaring growth in 2002 to 2005. In the last year and a half, China’s electrical generating capacity increased by an amount equal to the total capacity of Great Britain, which is now the fifth-largest world economy behind China, yet the country still has brownouts. China will continue to push all kinds of alternative energy, including the first solar-powered Olympics, coal to liquids and “green nukes” technology. I expect to find a recommendation or two in this area in 2007 and will let you know when the time is right to establish a position. In the meantime, Huaneng Power (HNP) is well-positioned to benefit from the economic slowdown by getting its electricity rates up as fuel prices moderate. HNP is a buy on dips under $30 for my $45 target. Their investment in green nukes technology continues, with the first small demonstration generating plant still scheduled to open in 2010.

The second factor that we will be keeping a close eye on is China’s currency, the yuan. The yuan took a big 4% jump since the U.S. November elections, on the theory that the Democrats will try to force it higher to appeal to their populist base. As a rule, populists don’t make good economists, and “watch out — you may get what your want” is likely to apply here. A more expensive yuan means higher prices at Wal-Mart, and although each administration seems to find more ways to recalculate inflation to show it isn’t there, a big jump in the yuan would be hard to hide. Due to Bernanke’s decision to destroy the value of the dollar by printing more green paper, the yuan is likely to rise at 5% to 6% a year anyway, for many years. Politicians talking about a 40% revaluation of the yuan are looking for a photo op, not to make sensible policy. The Japanese are playing the same game with the yen, pouring cash earned from exports into U.S. Treasury debt in order to keep the yen depressed and their nascent export-led recovery alive. Nobody complains about them, as the Chinese are quick to point out.

If you have investigated foreign currency checking and savings accounts to protect your cash from Helicopter Ben, you’ve probably found only the euro, yen and pound sterling as alternatives. I expect to see yuan accounts join that list in 2007.

One of the biggest supports for the Chinese economy and stock market is that U.S. institutional investors are starting to move meaningful percentages of their assets to China. The California Public Employee Retirement System (CALPERS) will be starting direct investments in Chinese companies in January, and they often lead the way for other public and private pension funds. This will be a many-year trend that will support our investments in China.

The final factor we’ll be watching in China is telecommunications. Right now China has almost 450 million cell phone users, more than any other country by far, yet they have not moved to 3G services and equipment. The government is playing a waiting game to give Chinese companies time to establish a lead in their home-grown standard, TD-SCDMA. Bending but not breaking World Trade Organization rules will help keep more of the business at home, as the country sails past 500 million users around July or August 2007.

UTStarcom (UTSI) will benefit from the long-awaited rollout of 3G cellular systems in 2007, as well as continued spending on Internet Protocol Television (IPTV) by the ever-growing Chinese urban middle class. With their financials straightened out and better internal controls in place, UTSI is a buy under $9 for my $15 target.

Content on Demand MegaShift

In what is best described as a lackluster holiday retail season, people still continued to buy consumer electronics at a rapid clip. Retailers offered deep discounts and special hours to get shoppers into stores, in order to try to revitalize lagging sales. On December 26, Macy’s opened many of its stores at 7 a.m., advertising 50% to 75% discounts, with an extra 15% off for Macy’s credit card users, another 20% off on jewelry and a further 10% off on merchandise in certain departments. It sounded like if you bought the right item, they’d pay you to take it away.

On Christmas day, new and existing iPod owners hit Apple’s website 41% more than last year. Consumer electronics sold before Christmas were one of the top areas for gifts and were one of the most popular ways to spend gift cards after Christmas. I expect strong growth to continue in 2007, driven by:

• Ever-lower prices for LCD TVs as the February 17, 2009 deadline to stop broadcasting analog TV signals approaches;
• Apple’s introduction of their iTV living room media control box and maybe the iPhone at Macworld in two weeks;
• 3G cell phones with better screens and controls at lower and lower prices introduced all year as the major manufacturers try to trump each other;
• Windows Vista driving a major laptop (and desktop) upgrade;
• WiMAX system deployment accelerating, led by Sprint Nextel;
• The fiber to the home build out continuing at a good clip, until most of America is wired by a phone company, a cable company, or both.

All of these enable and are being driven by the demand for content on demand — voice, video and data, wherever and whenever the customer wants. This revolution is the inevitable consequence of the Internet and touches the way people communicate, work and play. There could be no better examples of the New Economy triumph than the YouTube and MySpace phenomena. All old business models are up for grabs, and Internet-based entrepreneurs around the world are willing to take on long-established companies that don’t have a clue that the world has changed.

Because the video part of the voice-video-data equation is the hardest part, I want you to continue to hold Comcast (CMCSA) for my $62 target and be ready to buy Harmonic (HLIT) anytime it is below $7 for my $12 target. Existing buildings have to be retrofitted for broadband access, which means either an expensive rewiring job or a simple Broadband-over-Power lines installation from technology leader Telkonet (TKO), which remains a buy up to $5 for my $15 target in 2007. Companies still have to connect to the Internet via a telephone company or a cable company, and both of those suppliers are customers of Zhone Technologies (ZHNE), a low-risk buy at these levels up to $2.

Connecting all those consumer devices together easily requires an HDMI interface (there will be one in Apple’s iTV), and that continues to make Silicon Image (SIMG) a hold for my $18 target. We may get another buying opportunity in SIMG if the market cracks over the next few weeks. The company just settled a five-year-old patent lawsuit against Genesis Microchip, with Genesis agreeing to a royalty schedule and to cover part of SIMG’s legal costs. That will add an extra $2 million to $4 million in operating income to the December quarter, but Wall Street will probably ignore it as a one-time event.

New Energy Technology MegaShift

Warmer weather than expected across the U.S. has knocked natural gas prices down this week and helped pull down oil prices, in spite of Iran’s defiance of the toothless UN resolution that threatens sanctions if uranium enrichment does not stop. Iran responded by accelerating their enrichment program.

We used to have a saying that if it was raining in California in the winter, they were crying in Saudi Arabia. That’s because a wet winter out here usually meant a warm winter on the East Coast, with less demand for fuel. Well, we are wrapping up one of the driest Decembers that I can remember, but instead of the expected sub-freezing temperatures across the Midwest and East, it’s warm. I have friends who just moved from San Francisco to Saratoga Springs, NY, and even there it is a relatively balmy 42 degrees this afternoon.

So, either global warming is changing the weather pattern for good, or we are about to revert to the mean and see a return of cold weather. The January natural gas contract is the lowest it has been since July 2004, down 30% since the beginning of December. Yet the stock prices of most natural gas producers have held stable, both because gas production is still very profitable at current prices and because Canadian gas exports to the U.S. are expected to drop sharply. But there is a lot of gas in storage, and it will take colder weather to burn it up over the next few months.

Looking out to the rest of 2007, though, I think demand will stay strong as the U.S. goes through its slowdown or mild recession, and the rest of the world simply grows a little slower until this year’s flood of Fed liquidity gooses the real economy later in 2007. So I remain very positive on all of our energy technology stocks, and would buy any of them when they are under my limits. Connacher Oil & Gas (T.CLL), Gasco Energy (GSX), Infinity Energy Resources (IFNY) and Rentech (RTK) are all Top Buys. I would jump on any market-related decline in Ocean Power Technologies (OPWT), and I don’t see much risk in Plug Power (PLUG) or FuelCell Energy (FCEL).

Speaking of FuelCell, the company reported a bit worse than expected for their October fourth quarter, losing 47 cents a share compared to the consensus estimate for 35 cents. Revenues hit $9.1 million for the quarter and $33.3 million for the year, up 10% from $30.4 million in fiscal 2005. Product sales were up 24% for the year, while R&D contract revenues fell.

The disappointing growth hid a much better underlying situation, as they took costs out of their products, successfully turned on several showplace installations and engaged with more customers planning megawatt-class projects, which have a longer sales cycle. FCEL booked orders for 3.8 megawatts of generating capacity in the quarter, including 2.6 million from California, where they are the market leader. Their backlog rose to $27.9 million, up 39% from the July third-quarter figure. Yesterday, they submitted bids for 98.6 megawatts of fuel cell power projects to the Connecticut Clean Energy Fund for Project 100. Their project proposals ranged from 2.4 megawatts to 28 megawatts and were submitted in partnership with several developers. Project selections will be announced in March.

FCEL is making a crucial transition from a supplier of low-margin, sub-megawatt systems to profitable, multi-megawatt systems. I expect their financials to improve significantly in 2007, especially after the March wins in Connecticut. FCEL remains a buy up to $11 for a $22 target.

Holly Corp. (HOC) and Royal Dutch (RDS.A) remain good holds for higher oil prices, which are inevitable unless the economic slowdown is much worse than I am expecting.

New World Economy MegaShift

Omniture (OMTR) has moved up sharply since my recommendation, and I think this MegaShift holds tremendous promise for 2007. The new business models I referred to above in the Content on Demand update require new ways to think about software (as a service), marketing (online, real-time, personalized), information (ditto) and customer service (24/7/365). Online retail sales grew something like 25% this season according to comScore Networks, while the International Council of Shopping Centers is looking for a 2% increase in same-store holiday sales. Nominal retail sales probably rose 2.5%, so online sales grew 10X as fast. That’s getting too big and too fast to ignore. I’m looking for more investible ideas in this area, and still expecting to pick off Cnet (CNET) in a market decline. Our current holding in this MegaShift, Omniture, is trading well above my $10 buy limit, and pushing on towards my $20 target. Continue to hold OMTR, and be sure to pick up more shares on any dips below $10.

Nanotech & Materials MegaShift

The story in 2007 will be the same as in 2006, or 2008, 2009 and 2010: Fast growth from a small base, with few actual producers to invest in yet. The Integral Technologies (ITKG) recommendation has been wildly successful — we’re sitting on a nice 46% gain. And since ITKG quickly jumped above my buy limit, and even hit our first target, I will be raising the buy limit sometime soon to give you a second chance to get in or get more shares. I spend a lot of time in this area looking for ideas, because I am fascinated with the technology, and you will of course be the first to know when I find another buy recommendation. For now, continue to hold ITKG.

Security MegaShift

I don’t see anything good happening in Iraq, Iran, Saudi Arabia or even Afghanistan to make me think that the need for national and personal security will be lessened in the years to come. But at the same time, the spotty government efforts to create higher-level physical security and the disappointing level of improvements in Windows Vista security still make this an erratic area for investment results. I think @Road (ARDI) is definitely on the upswing, and with the stock nearing my short-term $8 target, I want to raise that target to $11 for 2007 and keep it as a hold. Our best chance to make a lot of money in this MegaShift is to grab American Science & Engineering (ASEI) anytime it trades under $59 for my $93 target.

Packeteer (PKTR) is a natural acquisition for any number of companies in 2007, and my $22 target is a reasonable buyout price. Buy PKTR under $11 in a market-related dip, and I will look at raising the buy limit a bit at that time, if necessary, to give you a shot at it.

Video iPod MegaShift

Macworld opens in San Francisco on January 9, and assuming he is still with the company (see below), Steve Jobs should introduce the long-awaited “real” video iPod, accompanied by an announcement of a settlement of the lawsuit with Burst.com (BRST). With BRST back below my $1.15 buy limit, it is safe to start or add to a holding for a $2 target when Apple settles or acquires them.

WiMAX MegaShift

Yea, it’s almost 2007! That means the WiMAX revolution can really begin, as orders, sales and earnings start to accelerate. The first half of 2006 went as I expected, with numerous onesie, twosie test installations. But the second half of the year just continued that pattern, while I was forecasting the serious rollout to begin. I think the rollout is a lock for 2007, if only due to the effect of the Sprint Nextel $3 billion WiMAX network build out on their competitors and other potential participants. All four of the recommended stocks are very undervalued, including especially MobilePro (MOBL), and I think your should have full positions right now, regardless of what the broad market does next. Buy MOBL under 25 cents for a 60-cent target; Airspan (AIRN) under $5 for a $10 target; Alvarion (ALVR) under $9 for an $18 target; and Terabeam (TRBM) under $4 for a $7 target.

Apple and Google

I wanted to make a couple of quick comments on Apple Computer (AAPL) and Google (GOOG), although I’m not quite ready to make a recommendation on either stock yet. Apple dropped as much as 5% Wednesday morning before regaining all of the loss to close up a penny on the day. The San Francisco Recorder, a legal newspaper, said that Federal prosecutors are examining Apple’s stock option documents to decide whether to file criminal charges. That is new news and an escalation from the previous level of expectations. But the cheerleaders said that it won’t hurt Apple or Steve Jobs, and there is not a chance that he will be leaving Apple.

I think that’s wrong, or at least expresses a lot more certainty than any outsider could know. The other, quieter announcement was that Steve Jobs has “decided” that he needs to hire his own attorney to deal with the SEC and the Justice Department from now on. Up to this point, Jobs has been represented by the company’s outside law firm.

One of the big advantages of being in and around Silicon Valley for 25 years is the déjà vu effect. I have seen this before. CEOs don’t usually hire their own counsel until the company counsel tells them that the company’s interests and the CEO’s interests have diverged. In other words, if Apple’s counsel has seen enough to believe that the company was hurt and the CEO was involved in it, they have the potential to represent the company in a lawsuit against the CEO, and therefore have to advise him that they can no longer represent him. I think the next announcement we will see is that Steve Jobs has been notified that he is the target of a criminal investigation. Then the Board will have a very difficult time doing anything other than suspending him until the investigation is over.

I think this is going to happen because I have been through the numbers, including what I believe is the largest stock option grant ever, to Steve Jobs in January 2000. Overall, since the current proxy disclosure rules started in 1994, Apple made 15 rounds of options grants through their September 2002 fiscal year. If you look at the price of those grants compared to the annual range of the stock for the six months prior to the grant and the six months following the grant, all 15 should average somewhere around the 50th percentile of the annual range. Some grants made right before the stock declined would be in higher percentiles, while others made right before the stock shot up would be in lower percentiles. But averaging all 15 rounds together, it seems reasonable to expect the 50th percentile if no funny business was going on.

Apple’s grants average in the 15th or 16th percentile. This is not conclusive proof that they backdated stock options, but it sure does look like they granted options right before they had reason to believe the stock was going to jump.

There are three transactions the SEC and Justice Department are probably looking at for backdating. One was on July 11, 1997, when Apple repriced options and executives turned in old options with a $7.44 strike price for an equal number of new options with a $3.31 strike price. There were only two other days in the 1997 fiscal year when the stock closed at a lower price. On August 6, only 26 days after the repricing date, the stock jumped 33% and then added another 11% on August 7. The question is whether someone decided on August 8 that July 11 would have been a great day to make the repricing effective.

A second case was January 17, 2001, when four top officers (not including Jobs) got options totaling two million shares at $8.41 a share. A few months before, on the last business day of the 2000 fiscal year, September 29, AAPL was cut in half when they preannounced an earnings shortfall. It kept dropping to the $8.41 option price, and then staged a nearly 60% rally in four months.

The third, and most serious case, is the giant 40 million share (split-adjusted) grant at $21.80 a share to Jobs on January 12, 2000. This one is a bit tricky, as the company has said that Jobs “didn’t benefit” because the stock eventually went below the option price. But here’s what really happened.

In the previous 26 trading days, AAPL fell 26%. Jobs then got his grant on the exact day the stock hit its low, and the stock rose 65% in the following 10 weeks. The issue, again, is whether someone decided in February or March that January 12 was a great day to price the boss’s options, it being the lowest price for many months. But AAPL eventually went back below the option price, and the options were cancelled. The company says due to “irregularities in the grants, the options were canceled and resulted in no financial gain to the CEO.”

Oh, really? This bunch of options would have expired in January 2010. Apple’s stock kept declining in the tech bear market, so the Board gave him 10-year options on another 15 million shares in October 2001. But the second batch went underwater, too, and on March 19, 2003, Jobs “voluntarily cancelled” all 55 million options. That’s why the company claims there was no financial benefit to him from the perfectly-timed 40 million share grant.

But the Board of Directors Compensation Committee report for that year disclosed that “in exchange for his cancelled options” Jobs was given 10 million split-adjusted shares worth around $75 million at the time. They were restricted from sale for three years, and when they became free to trade on March 19, 2006, they were worth $640 million. Not bad!

Here’s the rub, and I am indebted to compensation consultant Graef Crystal for doing the calculations. How did Apple’s Board decide on the number 10 million shares? Almost certainly, they used an options pricing model to calculate the current value of the options, which still had seven and eight years to expiration. Even though they were underwater on that day, the long time to expiration gave them value. Crystal used the Black-Scholes option pricing model to calculate the current value of the 55 million options: $77 million. That’s close enough to $75 million to believe this was their methodology.

But remember that the value of the options also depends on their strike price, and the very favorable strike price on the first 40 million grant raised their value quite a bit. If the strike prices of the two contracts had been set at the 50th percentile of the daily closing prices in their respective fiscal years, the calculated value on March 19, 2003, would have been $10 million less, around $67 million. So the Board might have given him, say, $65 million in shares instead of $75 million, or 8.7 million shares instead of 10 million. Those 8.7 million shares would have been worth $557 million when the sale restrictions expired on March 19, 2006, instead of $640 million. That’s an $83 million difference.

Yet in an October 4, 2006 filing with the SEC, Apple said: “In a few instances, Apple CEO Steve Jobs was aware that favorable grant dates had been selected, but he did not receive or otherwise benefit from these grants and was unaware of the accounting implications.” He didn’t receive the grants? He didn’t benefit from the grants? What about the $83 million? Get real.

This morning, news leaked out that the paper trail around the October 2001 grant (7.5 million shares at the time; 15 million split-adjusted) was falsified, sending AAPL down 65 cents on the day. Recently, Apple has been saying that, yes, there was something wrong with the first and maybe both of these grants, but Jobs was not aware of the “irregularities.” But Jobs also was CEO of Pixar at the time, which also appears to have backdated stock options. So, he is the only CEO of two companies to be caught in this scandal, and it looks to me like someone on the East Coast has decided to teach the freewheeling entrepreneurs on the West Coast a little lesson by nailing a very big target. I still think there is a substantial risk that Jobs will be forced to leave Apple, and therefore it is too risky to step into the stock yet.

Google (GOOG) is an interesting story. The stock has not been leading NASDAQ and the market up recently, after many months of being the poster child for the whole market upswing.

According to the market research firms, Google has about 50% of the search market, Yahoo has about 25%, MSN has about 12%, and dozens, if not hundreds, of others fight over the remaining 12%. Yet everyone I know that uses search-based marketing sees 80% to 90% of their traffic coming from Google, 10% to 15% from Yahoo, and maybe 3% from MSN. It’s hard to figure out for sure why the market research firms could be so off base, but it does explain why Yahoo is struggling so hard, and why no one anyone knows uses MSN search (yes, that’s an overstatement — I know someone does — please don’t email me to tell me you’re the one).

What that really means is Google is more mature than Wall Street thinks, there is less market share available for them to take, and a drop in ad spending in 2007 due to a soft economy is going to have some teeth. I’m still interested in shorting GOOG north of $500, maybe on this rally. Just not yet. As with Apple, I’ll let you know when the moment is right.

Market Outlook

Today’s housing data showed that prices of previously owned homes fell 10.7% year-over-year in November, and sales unexpectedly increased 0.6%. The housing bulls pronounced the recession in that sector as over, led by the chief economist of the National Association of Realtors, who said: “It appears we’ve hit bottom. The price drops are necessary to stir sales. It is working.”

In a recent Wall Street Journal survey, two-thirds of the economists polled agreed that “the worst of the housing bust is behind us.” Donald Kohn, the vice chairman of the Federal Reserve, recently said that “starts may be closer to their trough than to their peak” and that any overbuilding in 2004 and 2005 will be worked off in coming quarters, assuming the current level of housing starts continues.

You probably won’t be surprised to hear that I don’t think so.

In November, the supply of existing homes for sale was near the highest in more than 13 years, and that is where the 2007 housing problem lies. All one has to do is look at homes being completed and under construction to figure out that the glut in supply is going to get worse in 2007. I expect another down year as the housing boom of 2002-2005 continues to unravel, with accelerating foreclosures and little opportunity for consumers to pull out equity to maintain their spending levels.

In October, there was a record 4.3 million residential units for sale, including 1.95 million home completions, which was the 12th highest month since 1979. Units under construction stayed very high, so it will take most of 2007 for a reduction in starts to have any meaningful impact on the backlog of homes for sale.

Even worse, the Census Bureau collects the sales data and calculates the backlog of homes for sale from that, but they do not account for cancellations of home sales contracts. September-quarter earnings reports from the major homebuilders showed cancellation rates as high as 40%!

All this means housing will be a big drag on the economy again in 2007, with falling home prices and declining construction jobs. By the time the Bernanke Fed realizes that a stronger job market and rising wages are their only hope for avoiding a recession, rather than a reason to postpone cutting short-term interest rates, I expect it to be too late.

For the market, this still points to a sharp downturn over several weeks to readjust the recent enthusiasm to reality. The S&P 500 retested the 1414 level and rallied, so the odds still favor the last run up to 1440. But as I’ve said before, the longer it takes to grind up there, the faster and deeper the subsequent decline is likely to go. The best scenario would have been a dramatic rally to 1440 by the close of the year tomorrow, followed by a 125- to 150-point decline to around the 1295 breakout point. Now it looks like we could have some high-level volatility for a few weeks before that 1440 level is hit, followed by a deeper decline of 250 points to 300 points. We will let the market tell us when it is sold out, and in the meantime keep some powder dry.

Happy New Year

I learned a long time ago not to make New Year’s resolutions — all they do is hurt your self-esteem when you don’t keep them. I also don’t write down goals, except in the most general way as a description of how I want my life to be at some point. Then I release it to my subconscious to figure out how to get there.

Instead, what I do is write down the next steps that have to be done by me or someone else to move every project or situation forward. Then, after that step is accomplished, I immediately write down the following step again, noting resources needed, who is responsible, etc. I learned this process from David Allen, who wrote Getting Things Done: The Art of Stress-Free Productivity. If you must make a New Year’s resolution, resolve to read his book. It can put you in charge of what happens to you in 2007, and really give you a Happy New Year!

As the old year passes, it’s time to look forward to what will be happening in all of our MegaShifts in 2007. So, I want to discuss that topic in both this week and next week’s issues. This week, I want to first set the stage by talking about the major technology trends that will impact the economic and market environment for the next year or two before taking a look at a couple of our MegaShifts.

My economic forecast is pretty simple: sub-par GDP growth in the first two quarters of 2007, followed by accelerating growth for the last half of the year and 2008. “Sub-par” could still mean a mild recession, as in two quarters of negative growth, but it really doesn’t matter, because unless we have an energy price disaster, the Fed will eventually cut rates a bit and restart growth. In fact, even if there is an energy price disaster, Helicopter Ben will certainly continue to shower the economy with money, even if he doesn’t cut rates.

With business slowing as it is right now, capital spending budgets will be set conservatively for next year. In fact, capital spending should slow for the next three quarters. I think Windows Vista hardware upgrades will be a bright spot that keeps budgets from dropping significantly.

With that background, the best areas for investment will be those that can continue to show strong revenue growth. When everything is growing, it can be hard to stand out, but in 2007 we will see a real separation between maturing companies and wannabees on the one hand, and companies with real revenue growth on the other. Obviously, that is good news for almost all of our MegaShift stocks.

There are also a number of new or revitalized technology areas that I’ll be watching in 2007, many of which we already participate in. The whole Web 2.0 concept of social networking and user-driven content is accelerating, and one of the technologies it is driving is video over the Internet. This is a technology and a trend that has been growing from a small base for more than five years, and now it is ready to take off. It is part of a much larger trend, which is the effective use of the Internet — that great, free, universal, global network that links us all together socially and intellectually. And even that is taking place in the environment of a rapidly expanding Internet infrastructure, which includes everything from Google buying up thousands of miles of dark optical fiber to the new Internet Protocol 6 that starts serious deployment at the government level in 2007.

In the New Year, there are two major trends in semiconductors that will be worth watching. One is phase-change random access memory (PRAM). It will completely replace flash memory, dealing a special blow to Toshiba and SanDisk. PRAM uses a heat-sensitive chemical now used in rewritable disks to make memory that stores data 10X as long as flash memory and runs 30X faster. It is a Samsung innovation, with the prototype demonstrated in September and first devices available in 2008. That means 2007 will be the design-in phase, and I expect to hear rumors of flash memory losses and PRAM wins all year long.

The other semiconductor technology that I’ll be watching is the micro-electro-mechanical system (MEMS) chip. The best current example is the Texas Instruments digital light processing (DLP) chip with its masive array of tiny mirrors creating a TV image. Although the process of making MEMS chips is not easy, there are so many possible applications that I expect to see entire companies dedicated to making MEMS chips.

The white LED product from Cree (CREE) and Philips Lumiled are closely related to semiconductor manufacturing and 2007 should see this market take off. As I mentioned last week, I am looking for an entry point on Cree that discounts the poor results that they will show for the next three quarters.

In computing, the 2007 story is going to be Windows Vista and Office 2007. As you read the stories, remember that it is standard procedure for pundits to say the rollout of a new system is “disappointingly slow” and for Microsoft to have lots of bugs and security problems in the initial product. We are bound to see these kinds of stories in the first few months of next year, but by the end of the year, I think we will look back at the Vista rollout as a major event for 2007. I expect personal computer sales to be up 15% or more by the end of the year, because half of the computers already installed can’t run Vista, and the owners of most of the other half don’t want to go through the self-inflicted wound of trying to upgrade their operating system. It’s just simpler to buy new hardware with Vista already installed, especialy as Intel leaves the Pentium generation behind and moves on to the Core generation of microprocessors. Currently, the Core Duo dual-processor chip is the standard desktop processor, but by mid-2007 the Core Quad four-processor chip will be the sweet spot.

In communications, we all know that 2007 will be a huge year for wireless. The phone companies are selling wireless access to the Internet, and WiMAX is finally ready to really accelerate on the coattails of the $3 billion multi-year network rollout by Sprint Nextel. There will be new versions of Wi-Fi, too. But an interesting and overlooked area is the continued installation of fiber optic to the curb systems, both by phone companies (even those also committed to wireless) and cable companies completing their system upgrades. Of course, both wireless and fiberoptic technologies are being deployed around the world, not just in the U.S. Voice over Internet Protocol (VoIP) will continue to replace traditional telephone technology worldwide, in both the established phone companies and via new competitors.

The hottest area in communications is video, whether downloaded over the Internet, sent to a cell phone or personal media player, or just on a website. Google’s $1.65 billion purchase of unprofitable YouTube and Apple’s upcoming iTV video streaming/control box for your living room are just two examples of what’s coming as the analog TV signal goes dark in early 2009.

Popular Mechanics provides a Top 10 Technology Trends list at the end of each year. Many of them are gee-whiz ideas that make great stories but really are years away, while some are right on. Phase-change random access memory, the flash memory killer, is on their list this year. So is Body Area Networks (BAN), an idea that has been around for 15 or 20 years, but may soon see the light of day. A German startup, ImCoSys, says their new cell phone can send a weak electrical current, only a fraction of an amp, along your skin to control things like automatically logging into your PC as soon as you touch the mouse, or unlocking your car doors when you touch the handle. There may be secure identificaiton applications, too, that could attract some Homeland Security funding.

One software trend that is about to explode is software as a service, as exemplified by Salesforce.com. Instead of selling software to the corporate IT manager, Salesforce.com sells a hosted service directly to the user in sales or customer service. Our government has imposed so many new requirements on businesses in areas like hospital outcomes or storing and recalling emails for legal discovery that software as a service is sure to grow dramatically.

Another factor that will dramatically accelerate the adoption of the software as a service model is offshoring. The service is hosted, and in the Internet world it really doesn’t matter where the server is located. By locating offshore, companies can throw more people power at customer service and software upgrades for the same number of dollars. The Gartner market research firm says 30% of new software purchases will be delivered as a service.

In storage, Popular Mechanics also mentioned the “data cloud” that puts all of your files, music, photos and videos on centralized data servers with Internet access. The data cloud follows you wherever you go, and you can access it with whatever device you want. There’s a huge amount of storage wasted today in all the new electronic devices, PC back-up drives and so on. If it all sat on Google’s rumoured Gdrive, professionally secured and backed up in real-time, there would be much less need for redundant storage. Devices could be smaller and lighter, carrying only enough local storage for current projects or trips. While it is possible to put a data cloud together today, it is expensive and secure backup roughly doubles the cost. We may see the Gdrive, or something like it, by the end of 2007.

The bottom line is that 2007 is going to be a great year for new technology in many areas, almost regardless of what the economy does. It would take a very deep recession to stop this juggernaut, and with the Fed continuing to flood the economy with money, that just isn’t going to happen yet. So, let’s take a look at the individual MegaShifts in light of my outlook for 2007. This is Part I, and I’ll wrap up next week with the rest of the MegaShifts in Part II.

Avian Flu MegaShift

I still think it is inevitable that bird flu will be found in the U.S., and that it will mutate into a strain that is easily transmitted from person to person. Both of those things could have happened in 2006 and are even more likely to happen in 2007. But as I’ve been saying neither has to happen for us to make a lot of money in the stocks, as government demand to stockpile antivirals and vaccines drives up revenues at all three of our stocks.

BioCryst (BCRX) reported Fodosine data from three trials at the American Society of Hematology (ASH) annual meeting last Sunday, and the news was good. Fodosine treats certain types of leukemias and lymphomas. The first results were from a mid-study look at a Phase I/II trial of oral Fodosine for refractory (not responding to treatment) cutaneous T-cell lymphoma. Of the 34 patients evaluated, 14 had partial responses and three had complete responses, for an overall response rate of 50%. Those are good numbers for advanced lymphoma, and the safety data was good, so BioCryst will now start a Phase II trial.

The second trial was a Phase II study of patients with clinically active relapsed (it came back), refractory T-cell leukemia. Nine of the 50 patients had a complete response — a remarkable result. Even better, Fosodine restored normal blood cell development during the treatment, which means it may be useful as a targeted, less toxic therapy to treat the disease. BioCryst will do a “pivotal” Phase IIb trial, which means if they get similar results, they will file for approval.

The third trial was a Phase I safety study for relapsed, or refractory, B-cell acute lymphoblastic leukemia. As usual, the safety data was fine, and they saw some evidence of positive activity. Phase I trials are too small to say much more than that, but the company said that they intend to continue trials with Fodosine for this indication.

While I think the stock is worth more than its current price just based on their avian flu potential, there’s a lot more going on here. BioCryst is the best-situated stock in this MegaShift to make us a lot of money in 2007, as they complete their Phase II clinical trials of peramivir for both seasonal and avian flu. BCRX is a Top Buy all the way up to $19 for my $30 target.

Crucell (CRXL) got approval to start a Phase I safety trial of the malaria vaccine it is developing with the National Institutes of Health. This vaccine can be produced using Crucell’s cell-based technology, and would have a huge market if successful. CRXL remains a buy under $28 for my $50 target.

Gilead (GILD) announced good results from its Phase III trial of inhaled aztreonam lysine to treat people with cystic fibrosis who have lung infections. The drug allows them to stop antibiotic treatment for a month or more, in order to avoid developing a tolerance or sensitivity. The primary endpoint was postponing the time needed for inhaled or intravenous antibiotics, and they met it. Full results will be reported soon at a scientific meeting. Because this trial was done under a Special Protocol Assessment, Gilead should be able to file for approval.

The stock has been strong, and if you bought the January 2008 $50 LEAPs (YGDAJ), continue to hold for my $30 target. If you hold the January 2007 $60 contract (GDQAL), the LEAPs are in the money, but you may have a tax loss. Sell the January 2007 LEAPs now, and roll the proceeds into the January 2008 $50 contract.

Biotech MegaShift

In 2007, we should have a fully-functioning FDA and get numerous important drug approvals. In a big bull market, like the one I am expecting, defensive areas like health care normally go up, but underperform more cyclical areas like computing. However, biotech drug approvals will move a stock in any kind of market. With Acting Commissioner Andrew von Eschenbach finally approved by the Senate, 80-11, with only one Democrat voting against him, an uncertainty that has lasted for nine months should shortly come to an end.

Affymetrix (AFFX) is below my buy limit due to a Wall Street Journal Online story rehashing the Affymetrix/Illumina situation that I’ve discussed here before. There was nothing new in the story, so take this opportunity to buy AFFX under $24 for my $40 target.

Biogen Idec (BIIB) and their partner, Genentech, both fell after the FDA issued a warning to doctors that two patients taking Rituxan for lupus died from a rare brain disease. It is much too early to tell if there is any direct connection between the drug and the disease, as it often happens that these patients are on a cocktail of drugs and over-the-counter medications, and it could be an interference issue as it was with Biogen-Idec’s and Elan’s Tysabri. Rituxan is not approved for lupus, and the off-label lupus market is relatively small, so I think we should wait for further information before making any moves. I do not think Rituxan will be taken off the market. Rituxin was previously linked to the same rare disease in AIDS patients, and its label already carries a warning. Also, the FDA said the disease has occurred in lupus patients who have been prescribed other immunomodulator drugs besides Rituxin.

Last Friday, Biogen-Idec and Elan filed for a label expansion for Tysabri to cover Crohn’s disease, an inflammation of the digestive tract that causes pain and diarrhea in about one million people worldwide. Continue to buy the Biogen-Idec January 2008 $45 LEAP (YZUAI) under $12 for my $23 target, or higher.

eResearch (ERES) got an upgrade from Friedman Billings this morning, stopping the slide in the stock. I don’t think there is any fundamental change in the market or the company’s outlook, so this probably puts a floor under the stock. As they convert their high order rates, and now large backlog of business into revenues, the stock should recover quickly. Buy ERES all the way up to $16 for my $30 target as drug companies accelerate the required cardiac safety testing of all drugs currently in clinical trials.

Geron (GERN) said that preclinical work on its telomerase inhibitor drug showed that if the drug is given to knock out telomerase in tumors, it then makes the tumor cells more vulnerable to radiation. Longer-term use of the drug has been shown to slow tumor cell growth rates and dramatically reduce the ability of the cells to form new colonies.

This is very early work, of course, but is another indication that GERN may have the silver bullet for cancer. Buy GERN under $9 for my $18 trading target, and much higher levels as their anticancer and stem cell programs mature.

Market Outlook

After the S&P 500 breaks through a barrier (like the 1415 level), it tends to run up quickly, and then slowly give back ground to the breakout point. The purpose for that slow decline is to build up energy for the next move up, as some traders sell and some investors take the opportunity to get out stocks at better prices than they have seen. While this is complicated a bit by the approaching end-of-year tax deadline, so far this looks like a textbook dip back to 1415, to be followed by a final run up to the 1440 target. That easily could happen by the last trading day this year, December 29, and would set us up for a 150 point decline or worse to start the New Year.

I’ll keep an eye on these critical balance point levels like 1415, because if it does not hold we will know that there has been a real change in the underlying dynamics of the market. Likewise, if the market can just sail through 1440 I would say the two-year tech bull market has begun, and there won’t be any huge setbacks in the near future. So, while I am watching all this carefully, there is no change to my outlook yet.

Today is the Winter Solstice, so happy solstice to the pagans and druids out there, and Happy Holidays to all. I’ll be back with Part II of the 2007 MegaShift outlook on schedule next Thursday. Have a great time this weekend, be safe and remember to surprise a stranger with an act of kindness.

While stocks marked time going into what should be a small end-of-year rally that started today, some individual situations are getting interesting. Readers who were Technology Investing subscribers may remember Cree (CREE), the company that has the best chance of replacing all incandescent and fluorescent lights with white light-emitting diodes (LEDs), first in offices and later in homes. We bought CREE at $20.58 in March 2004 and sold it for a 38% gain in September 2004 at $28.50. The stock has been up and down since then, mostly down, and I’ve been tracking it closely since it went under $20 for a New Energy Technology MegaShift recommendation. Last week Cree preannounced a weak December quarter and the stock fell apart, touching $15.25.

To refresh your memory or for new subscribers who haven’t heard of Cree, let’s take a look at what makes this company tick. Cree’s basic technology involves making electronic devices on not only silicon wafers, but also on silicon carbide and gallium nitride. These are difficult materials, and Cree has numerous patents around its production technology as well as inventions. They have leveraged this technology base into several interesting product areas, but the two that will really drive the stock up are LEDs and power switching products.

In the LED area, their two most interesting areas are silicon carbide-based medium power LEDs for backlighting mobile phone displays and keyboards, and high-power packaged LEDs for lighting in homes and businesses, such as reading lamps or appliance lights. Cree made a lot of money with the medium-power products riding the wave of cell phone growth, but now their profits are being squeezed in that area by Asian competition. They make continual progress in increasing the power and brightness of the white LEDs for lighting, but that business is growing from a very small base.

The power switching products are mainly used in power factor correction circuits for power supplies in server and desktop computers. While that business will get a good bump from Windows Vista, it won’t be enough to hold off the margin erosion on medium-power LEDs for cell phones.

We’ve all seen these situations before, where the mature product line is going downhill while the new product line is growing strongly — think Zhone (ZHNE) — and Wall Street can get pretty impatient with flat to declining revenues and squeezed profit margins, no matter how exciting the new product line is. That’s what is afflicting Cree right now, and will for the next few quarters. Still, everything has its price, and there may be an opportunity to pick up CREE near or in the single digits over the next three months. I want you to be ready for that.

What’s the MegaShift?

Cree is in the New Energy Technology MegaShift, because the XLamp LED lights consume only 10% of the power of fluorescent lights, and last 10 times as long. The comparable numbers for incandescent lights are somewhere around 2% of the power and 50 times as long. Incandescent lights are a huge energy waster because they create large amounts of unneeded heat as a byproduct of creating light. The Department of Energy has estimated that switching to white LED lights would save an amazing 29% of our total energy consumption, and just replacing incandescent lights with white LEDs would cut our total oil use by 19%. Those are stunning numbers that make white LED technology a national strategic resource.

Cree scientists push the white LED technology down a curve similar to Moore’s Law, with power output doubling roughly every 18 months, and price per watt falling accordingly. So, it is just a matter of time until white LED lighting is cheaper than commercial fluorescent lighting, due to the 90% reduction in maintenance costs from not having to change lights so frequently. Cree recently announced their newest generation of XLamp products, which again doubled the brightness, and I think that crossover point is here, now. Late in 2007, assuming oil prices don’t plunge to $40, the crossover point for home incandescent lights will arrive. XLamp shipments should grow more than 100% a year for several years, and that is a MegaShift well worth catching.

Cree only has one major competitor, and although they are far behind, the name won’t surprise you: General Electric. Buying CREE now is like buying GE at the beginning of the electric light cycle, except GE was competing with whale oil and Cree will have to compete with GE. In 1999, GE and Emcore set up a joint venture, GELcore, to develop high-brightness LEDs. GELcore was working in LED traffic signals, indoor and outdoor signs, and specialty lighting applications, while developing products to compete with Cree’s XLamp. GE recently bought out Emcore’s 49% share for $100 million, valuing the whole operation at a modest $200 million.

Either Emcore was rooked, or GELcore isn’t making much progress, because I had expected them to have products ready for the market as early as 2008, and that should have been worth a lot more than $200 million. However, I am not going to discount GE’s R&D power, and they cannot afford to miss the replacement for the electric light bulb, so I am assuming that they will share the market with Cree. I suspect that they would buy Cree in a heartbeat, if the Justice Department would let them. Incidentally, Cree’s basic patent on their silicon carbide manufacturing process expires in 2007, and while there is a lot of know-how surrounding the use of that patent, this may give GE the wedge they need to enter the business at a competitive price. Cree has licensed technology to other companies to make white LEDs for various applications, and aggressively protects its patent estate. They recently sued BridgeLux for infringing on two Cree patents, one of which covered semiconductor devices manufactured using gallium nitride-based buffer technology.

The Outlook: Dim Near-Term, Brilliant To 2010

Cree has a June fiscal year. Their March third quarter was OK, with sales of $107.7 million and earnings of 27 cents a share. But cell phone inventories began to build towards the end of the March quarter, and in mid-July, they preannounced poor June-quarter results, missing their 22-cent to 24-cent estimate guidance and blaming price cutting for sales at the low end of their $106 million to $110 million forecast, which was accompanied by a drop in gross profit margins from the expected 46% to 47% range down to 42%. In August, Cree announced the final June fourth-quarter results: $106.7 million in sales and 17 cents a share. That brought them in at 98 cents a share for the year on $423 million is sales, compared to $1.18 on $384.5 million in fiscal 2005. The profit margin erosion was fierce.

The June 2007 fiscal year started out with modest expectations, and in the September quarter, they beat estimates by a penny, hitting 17 cents a share on $103.9 million in sales. But they forecast a decline in December quarter gross profit margins to 39% from 43%, indicating continuing price pressures, and a small increase in December-quarter operating expenses.

As it turned out, that was too enthusiastic. Last week the company said that they reduced their revenue target to $90 million to $92 million for the December quarter, blaming lower orders for LED chips for mobile phones. Cree said their gross profit margin would fall to 34% to 35%, and operating earnings would be only three cents to five cents a share. They will release final numbers after the close on January 18, and due to the seasonality in phone sales, if nothing else, I expect them to guide the March quarter to just as poor numbers.

One problem is that they opened a new 230,000-square-foot factory in the Research Triangle Park in North Carolina, and they now have to start taking the depreciation on it. This gives them lots of capacity to produce their silicon carbide and gallium nitride devices, but it comes at a time when the actual volume of mobile phone chip sales may dip for a couple of more quarters. It will be a great capacity to have when XLamp sales take off, but for now it is a drag on profits.

At this point, you might be wondering why I am telling you about CREE before I hear the March-quarter guidance. The answer is that the end of the year is approaching, and there could be enough tax-loss and window-dressing selling in CREE, especially in the context of a weaker market, to drive it to new 52-week lows. Taxable accounts need to book losses by December 29, and institutions often sell losers (window-dress) to make the portfolio look better, and so they won’t have to talk about them to their clients.

CREE suffered the “death cross” when the 50-day moving average went below the 200-day moving average on June 23, and the stock closed at $23.49. It suffered the “mini-death cross” on November 20, when the 10-day moving average went below the 50-day moving average and the stock closed at $20.72. There is very little technical support if tax-loss selling or institutional window-dressing selling hits. A break below the December 7 intraday low of $15.25 could put the stock in single digits, and I would be very interested in buying it anywhere under $10.

At today’s close of $17.42, CREE is selling for 46.5X my 35-cent estimate for the June 2007 fiscal year, and 3.5X projected sales per share. The consensus estimate before this latest disappointment was 69 cents, and the stock is currently at 25.5X that number. So, it is not stunningly cheap on this year’s results. However, analysts cut their June 2008 estimates from 91 cents a share to 60 cents a share on $456.2 million in sales. I suspect that’s low, as the XLamp finally starts to sell, and I would be looking at something closer to 80 cents on $480 million or more in sales. So, if we are willing to look ahead to fiscal 2008, which will start in six months, the stock is at 22X earnings. That’s reasonable, but I’m not sure we could get a double or better out of it if we bought at the current price.

But look how interesting it gets if we see the stock trading at $10 or so. The P/E on this year’s depressed earnings falls to 28.5X, but on next year’s to a very attractive 12.5X. The price/sales ratio falls to around 2X this fiscal year’s forecast and only 1.6X fiscal 2008. I would be willing to step up to the plate at that price, even before the January conference call.

So, read up on CREE, watch the stock and stay tuned — you may see a Flash Alert in the next two weeks to buy the stock.

New Energy Technology MegaShift

We are starting to see quite a divergence in the outlook for oil prices. The International Energy Agency said that its global oil demand forecast remains unchanged at 84.5 million barrels a day in 2006, growing 1.66% to 85.9 million barrels a day in 2007. They added that the 2007 forecast faces downside risk due to uncertainties over the U.S. economy. My expectation always has been for a short, shallow recession at the worst, so I think their forecast is either on the button or a tad low.

However, the World Bank begs to differ. Earlier this week, they published a forecast that oil prices will slide to $56 a barrel in 2007 and below $53 in 2008, based on increasing supplies and slower demand growth. They even went further, saying: “The basic assumption is that because of the (economic) adjustments we are observing now, there is a tendency for oil prices to move in the long run to around $40 a barrel.”

I really wonder what those adjustments are, as I think it would take a significant, drawn-out recession in the U.S. that would boomerang through Asia to get anywhere near $40 a barrel. Remember that international oil transactions are priced in dollars, and the dollar is falling rapidly, which means the dollar price of assets must go up.

Just to cover their backsides, the World Bank did say: “Over the medium term, limited spare capacity and strong global (economic) growth suggest that oil prices will remain volatile.”

They think that world output capacity will increase by 15 million barrels a day by 2010, an average annual increase of three million barrels a day. While that is far above the expected increase in annual demand of 1.2 million to 2 million barrels a day, it is utterly unrealistic. The World Bank cited new production from Africa, but Nigeria has taught us that there are major political problems once the oil starts to flow, as various factions argue over who is going to steal the revenues and get them into a Swiss bank. The World Bank also cited Saudi Arabia, which can only produce a little more oil per day without having their wells flood with water, and the incremental oil is sour crude for which there is no more refining capacity.

The World Bank concluded by warning that spare production capacity is only three million barrels a day today, so global oil markets remain vulnerable to supply shocks. They added: “Because no country can easily ramp up production, if output in a producing country were to fall significantly, world supply would fall, provoking a decline in economic activity.” Somehow, I don’t think oil prices would go down in that scenario, even if there were a decline in world economic activity, which I doubt will happen.

The price of oil has been sneaking up lately as OPEC threatens to cut production further, and with the dead of winter just ahead, you should be fully invested in stocks like Connacher Oil & Gas (T.CLL), Fuel Cell Energy (FCEL), Gasco Energy (GSX), Infinity Energy Resources (IFNY), Plug Power (PLUG) and Rentech (RTK).

Content on Demand MegaShift

Telkonet (TKO) shareholders should have received a December 4 letter to shareholders that was a thorough summary of all the activity on several fronts related to Broadband over Power Lines and high-speed wireless Internet access. If you didn’t see it, go to the company web site at www.telkonet.com and check it out.

This morning, TKO was the subject of an update report from Dutton Associates, reiterating their $4 target. You can download the report free from here. Obviously, I think their “target” is much too low, as is common in these kinds of reports, where they raise the target as the stock price increases. I would rather tell you right upfront what I think the stock can get to in a reasonable time period. Continue to buy TKO under $5 for a move to $15 as their government and commercial deployments accelerate.

Video iPod MegaShift

Burst.com (BRST) drew an email from Neville: “If Apple is going to launch their iPhone at Macworld in January, should we sell Burst.com now before they try to tough it out in court with Steve Jobs?”

I don’t think the iPhone will use any of Burst’s technology that the current video iPod doesn’t already infringe. Whether the iPhone is introduced or not, Apple has to settle with Burst soon, or buy them out, because Microsoft already has a license from Burst and can start leveraging video streaming technologies to get their new Zune ahead of Apple. This is a game of who blinks first, and I think Apple will blink. So continue to buy BRST while it is under $1.15, for my $2 target.

WiMAX MegaShift

Lawrence asked: “What is going on with MobilePro? Is it worth the wait for a potential move up? Is it still growing its revenue?”

This week, MobilePro (MOBL) completed the initial phase of deployment for its Longmont, Colorado, Wi-Fi network. This company-owned network covers about 22 square miles, and was installed in less than 90 days. Sales in the March 2005 fiscal year hit $46.5 million, and then increased 113% to $99.0 million for the March 2006 year, in part due to acquisitions. They’ve been stalled at just over $23 million per quarter for the last three quarters, but I think the new Wi-Fi deployments will get revenue growing again. The problem with the stock relates to their financial situation, and management is working on raising new money on less dilutive terms. They are the clear leader in actual municipal Wi-Fi deployments, and I still think MOBL is a buy all the way up to 25 cents a share for a 60-cent target.

Market Outlook

I’ve been saying that the 1407 to 1415 range on the S&P 500 was crucial, and whichever way the market broke would determine the market’s direction for the next few months. Today’s break over 1415 should be followed by a very quick run up to 1440 over the next few days, and then a dramatic drop, at least to 1325, and maybe under 1300. I think (and hope) 1040 is off the table for now, but we will have to see how much the market overshoots before we can step back in.

In the current case, the extended uptrend since July and current low volatility readings, supported by a complacent Fed and decent consumer holiday spending, will make it hard for the S&P 500 to extend much beyond 1440. A quick, scary downturn will push the hedge funds to sell short very quickly, and that reloads the springboard for the subsequent move up. A strong two-year bull market led by technology is still the next step after the decline is over.

The most likely path for the market in 2007 remains up because the most likely thing for the Fed to do is continue to pour liquidity into the economy. I have never been one to rant about “destruction of the dollar” and “buy gold,” but I must say that Helicopter Ben seems to be even more determined in this regard than the Greenspan Fed. I’ve often mentioned that the very public Fed funds rate simply sets the price of short-term money. It is the Fed’s open market purchases and sales that sets the quantity of money. Year to date, the Bernanke Fed has grown Fed funds and repos (repurchase agreements with banks, which create money) by $366 billion, or 24% annualized. Fed funds and repos grew 14.5% in 2005, which was too fast in my book, as it will ignite inflation and weaken the dollar. By accelerating to 24%, Bernanke makes it almost impossible to hold the value of the dollar. So assets priced in dollars have to go up in stated price as the dollar declines in real value — oil, U.S. real estate, stocks, gold, silver, lumber, etc.

In the short term, the economy looks good and people are happy. With long-term rates well below short rates, people can restart refinancing their houses and pulling out equity. The real estate markets will recover, especially as soon as the Fed cuts short rates and makes adjustable rate mortgages attractive again. Stocks will go up in dollar terms in the two-year bull market led by technology. If people are really happy, they will vote Republican in the 2008 election and President Bush will have recovered from the 2006 drubbing.

But if this scenario plays out, you will see $900 gold and $80 oil in 2007, with higher prices in 2008. Importers like Wal-Mart will squeeze their suppliers as much as possible, but prices will start to climb. Even if the Fed ignores the inflation, as they have so far, at some point the loss in the value of the dollar will spiral out of control. A country can’t grow money at 24% a year and expect to have a stable currency, and a Fed that has been pumping liquidity that fast can’t slow down without causing a very serious recession or depression.

But that’s a worry for 2009-2010, not now. Our concern now is getting back in the market at a time and price where the short-term risk is out, and we can reasonably expect to book doubles and triples in the MegaShift stocks that will lead the next upturn. That time is coming, but it is not here yet.

Lynda asked a question that is on many subscribers’ minds as the deadline for tax-loss selling approaches: “Your prediction of a further downturn leaves me wondering what to do. Should I sell any shares that just manage to tip over into profit, or shall I hang in for the upturn some time in 2007?”

You should hang on. First, selling winners just because they are winners and keeping losers just because they are losers is called picking the flowers and watering the weeds. Not a good idea. Second, I believe the brunt of the coming decline will be in big-cap stocks, just as the bulk of the run-up since July has been in big-cap stocks. So, the action in the broad market indices may look scary, but it should not affect us much. Finally, as analysts look forward to 2007 and companies start to give guidance, the MegaShift areas that are growing rapidly will look more and more attractive. I would not be surprised to see the whole downside scenario play out in a few weeks, with little damage to our stocks. Start thinking about what you’ll want to buy, not about what you might sell.

Christmas time is here, by golly

Disapproval would be folly

Deck the halls with hunks of holly

Fill the cup and don’t say when.

Relations sparing no expense will

Send some useless old utensil

Or a matching pen and pencil

Just the thing I need — how nice.

Tom Lehrer, the author of the above anti-Christmas carol, was an associate professor of mathematics at Harvard when I was there and when he released his first album with this tune. For the past few years, I’ve dedicated one issue to explaining popular technology gifts and alerting subscribers to unknown advancements. Since most of us have already started our holiday shopping, this issue of your Radar Report is dedicated to those who want to avoid being either the giver or the receiver of one of those useless old utensils. The following are my top picks for a technology gadget gift for the holiday season that will not have people humming Professor Lehrer’s song. There are so many cool tech presents for the holidays that I am not ranking these — they could each be #1 for somebody.

Manage Your Media

Do you remember the first portable media player? It was the Regency TR-1 transistor radio, and it came along at the end of 1954, just in time to let us carry Shake, Rattle and Roll and other early Rock ‘n’ Roll hits with us. That meant any flat area was a potential dance floor, so it was a great way to attract girls. It was brutally expensive, though, at $49.95 — about $370 in 2006 dollars. Three years later, Sony broke the $30 barrier just after Hound Dog went to #1, and that was pretty much the portable media story until late 1979, when Sony introduced the Walkman and put the listener in charge of the play list by making portable stereo audio cassettes the hot item.

While the years have passed and the charts are being topped by new, young artists, the desire for portable media players has not changed. This season there are two hot portable media players at the top of any music lover’s list. One is the latest top-of-the-line iPod with a 2.5″ screen and 80 gigabyte hard drive that stores 20,000 songs, 25,000 photos or 100 hours of video for $349.

Steve Jobs is twice as customer-centric as Henry Ford was, because you can get the iPod in any color you want as long at it is black — or white. Sadly, Microsoft’s Zune MP3 player is getting off to a slow start, and while it is far from a useless utensil, it will not substitute for an iPod in that brand-conscious teenager’s stocking.

Seward asked: “I am curious as to why you didn’t come back to Apple Computer as you suggested you would? The stock basically fulfilled your premise of a sharp pullback during the changeover to Intel, but since touching $50.16 on July 14, the stock has appreciated more than 82% on positive news regarding the changeover, the popularity of the Macbook line, excitement over Apple’s probable entry into the handset market, and iTv. Many of the stocks that you cover are microcaps so I would have thought that you would have come back to Apple in order to offer your clients a big-cap name with exciting growth prospects. What’s your take?”

Maybe I have missed Apple for good, but there is a very worrisome problem overhanging the stock. There is no doubt Steve Jobs knew about the options backdating at both Apple and Pixar, and no doubt that he benefited from it at Apple (in spite of what the company says). The SEC has picked out various CEOs to pursue hammer and tongs on this issue, and here is one who was CEO of two companies that cheated. Will they give him a pass because he is Steve Jobs? Maybe. But I think there is a real risk that they decide to make a high-profile example of him, and we get a sudden, shocking announcement that the SEC has notified him that he is the target of an investigation. That would be devastating to the stock, and I decided until this issue is put to bed for good, we would be taking too much risk to go back into Apple at this time.

If the iPod is too unimaginative a gift for you, the other, more unusual choice is the Samsung Helix XM radio tuner and MP3 player. XM satellite radio has over 170 channels, about 70 of which are commercial-free. Samsung put in an FM transmitter, so you can listen through your car or home audio system.

You also can record from the XM radio to a one gigabyte hard drive that can hold almost 50 hours of programming. It will cost you about $185 for the device and another $70 for the car kit. XM radio charges $10 to $13 a month, depending on your contract.

Both XM Satellite Radio (XMSR) and Sirius Satellite (SIRI) are building their businesses by spending far more on marketing than their current revenue base can cover, leading to huge quarterly losses. XMSR has seen a director resign and publicly say that they are headed for a financial meltdown, while SIRI took both stocks down sharply on Tuesday by cutting their 2006 subscriber forecast to 5.9 million from a range of 6.1 million to 6.3 million. That was a big reduction with only three weeks to go in the year, and their implication that the reduction was due to a weak retail environment didn’t add much light. In 2005, they added 500,000 subscribers in the last 10 days of the year as people got in line for Howard Stern’s debut on Sirius radio, but it is hard to believe they thought they had any chance to match that pace this year. More likely, the iPod is taking eardrum share from satellite radio. While there are constant rumors that the two services will merge, and then probably raise prices, I think we should continue to sit this one out until profits are at least on the horizon.

Bling Your Ring

If you are more interested in talking than listening, but still want your tunes with you, the disappointing Motorola Rokr evolved into the much hotter Razr V3i cellphone plus.

The first plus is that it can play iTunes, although it is still limited to storage for 100 songs. The second plus is a 1.23 megapixel digital camera with 8X digital zoom. The camera also will record short videos and play them back on the very nice 2.25″ color display. Other pluses include Bluetooth Class 1 wireless technology to communicate with a lightweight headset and 3D graphics. Get the gold Dolce & Gabbana case and for around $215 you will have the flashiest cellphone/iTunes combo for almost two weeks, until Apple introduces the iPhone at Macworld in Janaury.

The cell phone is described as the black hole of Silicon Valley, because it takes many products that were profitable to a whole food chain of suppliers, and turns them into features on a cell phone that’s built by people who calculate their costs out to the fourth decimal. When your phone is your camera, your camcorder, your Internet access device, your MP3 player and your organizer, why would you want to carry anything else? That’s why Palm had to introduce the Treo PDA/cell phone, and why Apple has to introduce an iPod/cell phone. I am always looking for interesting companies that supply this industry, even though I am licking my wounds over PortalPlayer (PLAY). As I said back in November, PLAY agreed to an acquisition by Nvidia (NVDA) for just $13.50 a share. And while I thought a bidding war could start, it doesn’t look like there will be another bid for that company at this time. So go ahead and sell the PLAY now.

Shift Your Show

This season, the media toy of choice is the Slingbox, which forwards whatever is on your TV (live shows like NFL Sunday Ticket, or anything that is stored on your TiVO) to any Internet-connected PC, laptop, cellphone or PDA anywhere in the world.

Oh, you can change channels, too, and it will only cost you $135 or so. Slingmedia is still private, and we may never own it because there will be dozens of small suppliers of video-enhancing gear to catch our attention. There’s no denying that the video explosion is upon us, including video weblogs, or vlogs, as well as the YouTube phenomenon. That’s great news for Harmonic (HLIT), Packeteer (PKTR) and Comcast (CMCSA). I would not be surprised to see these three stocks at the top of the performance derby in 2007, especially HLIT. I will raise my buy limit on HLIT and PKTR if a market decline doesn’t bring them down first.

Pay to Play

On to video game consoles, where you can do no wrong with any of the new generation: Microsoft’s Xbox 360, Sony’s PlayStation 3 and Nintendo’s Wii (pronounced “we”).

The latter two are pretty much sold out. Remember all those people camped out in front of Targets, Wal-Marts and Best Buys? Well, that’s why. So both PlayStation 3 and Wii will earn you extra points if you gift a gamer with either of them. You can get an Xbox 360 for around $430, the PlayStation 3 with a 60 gigabyte hard drive for $850 (if you can even find one) and the Nintendo Wii for $640.

The development codename for Wii was “Revolution,” and I think they should have kept it. This is the video game console that could make us a nation of video game players instead of card game players. Nintendo wanted to de-emphasize the fast twitch factor beloved by kids, and make video games intuitive, engaging, social and more physical. The control pad looks like a remote control, and it has a very sensitive motion sensor that picks up movement or rotation in three dimensions. The game players can get up and move around, making their character on the screen get up and move, or slashing their remote through the air to control the light saber, baseball bat or tennis racket on the screen. Wii Sports comes free with every system, and in Wii Tennis you can put spin on the ball as you return your opponent’s serve, hitting as hard or gently as you like. It is an immersive experience that will be much more attractive to people who were not interested in playing video games before. People even enjoy watching others play with Wii, which makes it a new party or family experience. Although the Sony PlayStation 3 controller also has a motion sensor, it is much less precise than Nintendo’s.

The video game stocks seem overpriced in anticipation of another up cycle in the industry, so the opportunity here is again with Harmonic and Packeteer because all three of these consoles can play games online. The explosive demand for video and storage will also drive a number of our new MegaShift investments in 2007 — I’ll talk about that more in the coming 2007 forecast issues.

The Right Shot

Digital cameras have been super presents every holiday season this century, because every year the picture quality (number of megapixels) at each price point improves dramatically. This year, you can give a point-and-shoot camera for less than $250 that will have five or six megapixel resolution and a 6X to 12X optical zoom. A good example is the Canon PowerShot S2 IS for $250.

You can ask for a $1,500 digital single lens reflex with great swappable lenses, eight to ten megapixel resolution, burst mode pictures at five frames a second, and a shutter release lag (the #1 thing people hate about digital cameras) of less than 50 milliseconds. Check out the Nikon D80 10.2 Megapixel SLR Digital Camera with an 18-200mm lens kit for $1,650.

Or if you really want to blow everyone away, pony up $5,800 for a Canon EOS 1Ds Mark II with an amazing 16.7 megapixel resolution and the ability to shoot 32 pictures at four frames per second.

As cell phone cameras gain functionality, pure digital cameras will be chased to higher and higher megapixel levels at each price point. But eventually this market is likely to bifurcate into the cell phone with a 20 megapixel resolution camera/camcorder at the low end, and the high-end single lens reflex with an array of lenses for professional use. Our opportunity comes in finding some new investments for 2007 that will benefit from the tremendous additional demand for digital storage of all these pictures and video clips.

Know Your Stats

The gripping and ultimately sad story of CNET editor James Kim’s death while trying to save his family in the Oregon wilderness has led me to put this item on the list: The Garmin Forerunner 305 GPS receiver.

About 35% of marathon runners use a GPS device to keep on track. This one not only tracks your location, it also measures your heart rate, speed, distance, pace and calories burned. If you, like so many New World Investor readers, jog, run, bike, hike, ski, snowmobile, camp or sail for health or recreation, this $260 monitor will make it more fun, and might someday save your life.

We made 59% from our first investment in SiRF Technology (SIRF), a manufacturer of GPS chips. I’m looking for an opportunity to get back into SIRF, and I’d like to add Garmin (GRMN) at the right price. Though this GPS device is only a holiday gift, products that provide location information will become more and more in demand. Just watch Google take over the world, as they deliver highly targeted, location-sensitive ads to your cell phone, Wi-Fi or WiMAX device. What we’re seeing now are the early stages of a MegaShift, and we will put our money on the table when the true winners come down to more attractive prices.

A Clean Sweep

If you know someone who loves to vacuum, do not give them a Roomba or a Scooba. The Roomba vacuums floors and rugs on its own — no physical exertion from you required. And that’s not all. It also takes itself back to the recharging station when necessary.

Models range from $150 to $350, depending on features, but I personally want two: The $300 Roomba Discovery for Pets to follow my Great Pyrenees around all day, and the $130 Dirt Dog Workshop Robot that will pick up nuts, bolts, nails, wood shavings and various other junk from my shop/garage floor.

The Scooba 5800 is a bagless floor washing robot for hard-surface floors. It runs around the room sweeping up dirt, washing, scrubbing and drying in one pass.

It cleans 250 square feet on a single tank while the human is doing something more interesting. It costs $300, and the bigger 5900 model that cleans 500 square feet costs $400.

iRobot (IRBT), the manufacturer, is a public company that I have been tracking for about a year for a MegaShift investment. The stock has been almost cut in half since a Motley Fool recommendation early this year, but still sells for 65X next year’s earnings. I’d like to see it around $15 to start building a position.

A Swiss Improved Standard

Finally, here is my favorite stocking-stuffer this year: A Swiss Army knife with a knife blade, scissors, a file with screwdriver, built-in ballpoint pen, red laser light and — wait for it — a one gigabyte USB flash drive.

There’s a 128 megabyte version for $45 and a 512 megabyte version for $85, but the top-of-the-line one gigabyte model is the way to go, if you can swing the $120 price tag. Incidentally, you can remove the USB drive to carry it on a plane, while putting the knife in your checked luggage. It’s 2.4″ long and weighs 1.2 ounces. SanDisk (SNDK) would be the most likely investment in this area, as the company designs and develops flash storage card products. Unfortunately, there is a glut of flash memory production capacity, so I would not buy SanDisk right now.

Tech Gifts for the Rich and Their Kids

Just in case this is your year to give a great, memorable gift to the person that has everything, how about a $1.7 million trip for six into space on Richard Branson’s SpaceShipTwo, debuting in 2009? You have to get in line for the Virgin Galactic trip now, which will shoot you 63 miles up to weightless orbit. After you come down, the astronauts plus six guests get a four-day stay at Branson’s Necker Island resort, and those who were actually shot up into outer space get the luxury version of those little tin wings United Airlines used to give away. Maybe if you contract to do some biotech or nanotech experiments in space, you can pay for the trip.

If you want a “greener” present, there’s a human/electric hybrid commuter vehicle for two called the Twike in the Neiman-Marcus catalog for $40,000. I haven’t found out yet if it uses Energy Conversion Devices (ENER) batteries, but I have not forgotten that we want to get back into that stock soon. I’ll be sure to let you know when the time is right.

So, what about the younger names on the wealthy shopping lists? My four-year-old thinks her play-acting imaginary friends and ever-changing collection of woolly bears, frogs and snails are the best toys around. The doll house, jump rope and two-wheel bicycle with training wheels that Santa is likely to leave will blow her away. TMX Elmo is not welcome. But some kids are on a different track, so the $300 animatronic Butterscotch pony will introduce many children to robotics this holiday season. She is three feet tall with moving eyes, ears, head and tail. She can whinny, snort and can be “fed” a carrot. If children sit on her she will “gently bounce,” as opposed to the death-defying act my daughter performs on her $30 rocking horse, Flyer.

For children not quite old enough for their own cell phone, which these days seems to mean those still in single digits, Hasbro has the $75 ChatNow two-way radio that looks like a flip-style cell phone. Kids can change the faceplate, just like their teenage older siblings, and it takes and stores up to 30 digital photos. Or they may like the $249 Zoombox projector that takes a DVD or video console input and projects games and movies on the ceiling or wall up to 60 inches diagonally. Instead of making the effort to sit on a couch, they can lie on the floor and watch even more TV as a rug potato.

For slightly older kids, I guess the Erector set is out. (I am looking forward to Christmas 2011, when the top-of-the-line Erector set will finally be mine…I mean, my daughter’s.) Instead, parents are buying Lego’s Mindstorm NXT, a wireless robot that can be programmed from a PC. It’s only $249, and at least the kid might be upright and moving around for a few minutes of their play time.

The Bottom Line

If you head out to the mall to buy any of these gifts, you’ll be joining a lot of others this year. If you head online, you’ll be part of an even faster growing trend. The large increase in retail buying on Black Friday weekend following Thanksgiving did not hold up, as I expected, but it’s still looking like a decent holiday season. The National Retail Federation predicts that consumers will spend $457 billion this season on themselves and presents. Of that, online sales in November and December will rise 22% from last year to $138 billion — good news for Amazon, eBay, Yahoo, Overstock.com and others.

A major part of that will be consumer electronics — very good news for Silicon Image (SIMG). Surveys show that more than 50% of buyers say they will spend more on consumer electronics this year — the highest percentage in the last three years. The big winners are iPods (named by over 12% of buyers), LCD TVs (15%) and digital cameras (over 25%), especially those made by Canon — no surprise there. Technology continues to gain share and roll on, and as I discussed in last week’s long-term outlook, these trends won’t stop for many, many years.

In the near term, there hasn’t been a lot of news, but what there was will make a big difference to some of our companies and MegaShifts. Let’s take a look at them now.

Avian Flu MegaShift

Crucell (CRXL) has not yet licensed their cell-based vaccine production technology to Medimmune, but I still expect that to happen. Medimmune just filed an Investigational New Drug application with the FDA for a cell-culture-based seasonal influenza vaccine, which they are developing under a $170 million contract with the U. S. Department of Health and Human Services (HHS). HHS is worried that the current technology using chicken eggs as the production medium limits scalability in manufacturing, slows response time and increases the potential risk of manufacturing delays or supply shortages. A severe outbreak of avian flu could kill the chicken flocks used to produce the eggs that would be used for vaccine production. Crucell has the basic patents in this area and has licensed it to Sanofi-Aventis for a flu product. Therefore, Crucell has to defend its patent estate by getting Medimmune to sign a license agreement. Crucell is a buy up to $28 for my $50 target.

Biotech MegaShift

Pfizer suffered a major blow when they had to stop development of torcetrapib, a drug intended to increase HDL cholesterol, rather than put patients through the difficult task of actually eating a healthy diet (pardon the sarcasm). In a 15,000 person trial, torcetrapib had the unfortunate side effect of causing high blood pressure with sometimes fatal results.

This has caused a lot of bloviating in the biotech investor world about how the big drug companies will now have to start buying biotech companies to fill their pipelines. Actually, that process started in March 2003 when Johnson & Johnson (JNJ) acquired Scios and JNJ stock went up. Before that, Wall Street held Big Pharma to a very strict quarterly earnings standard, with no room for potential dilution of any kind. But JNJ bought Scios, said it would dilute their earnings for three quarters before becoming accretive, and the stock went up because the long-term pipeline improvement outweighed the short-term earnings impact. It was a defining moment in biotech investing.

Pfizer, like every big pharma and big biotech, has been reviewing potential acquisitions to the tune of hundreds per year, and that will not change. It still makes little sense for them to buy development stage technology that may not work in humans. Merck’s acquisition of Sirna, which had earlier acquired a biotech called Ribozyme Pharmaceuticals that I was involved in, is an exception and a Hail Mary pass after the Vioxx disaster. I think we will continue to make the most money focusing on late-stage clinical trials and approved products, as those companies are most likely to form major Big Pharma partnerships or be bought out. The only early-stage biotech stocks that should be bought are those about to announce great Phase I or Phase II clinical results, for a trade, or those that can create a MegaShift of their own if their technology works, like Geron (GERN).

As I pointed out right after the election, passing the Missouri initiative to allow stem cell research was a big win for Geron and medical research. With the Democrats in control of Congress and the Republicans split on the issue, stem cell politics will be in the news for two years as an easy way to embarrass President Bush. The stock popped up Monday on a recommendation by another newsletter, but after it settles back a bit GERN is an excellent buy anytime it is under $9 for my $18 target.

Market Outlook

The S&P 500 is fibrillating in a 1407 to 1415 range, and as I’ve been saying, the longer this goes on, the worse it is for stocks. That’s because a decisive move over 1415 should extend all the way up to 1440 in early January, while a sharp break under 1407 could easily take 100 points off the S&P in a few weeks, and set us up for the two-year bull market that is coming, led by technology. The worst case is continued high-level volatility, as that would suggest the whole first half of 2007 could be difficult.

There’s really not much to do except watch and wait to see which way it breaks. Tomorrow’s labor report for November could be a catalyst, but the real killer is likely to be an increase in inflation rates even as the economy is stagnating. U.S. manufacturing unexpectedly shrank in November for the first time in three years, suggesting that the housing slowdown is now spreading through the economy. That’s why the labor numbers should be weak tomorrow, giving more fuel to the bulls who are touting a Fed rate cut as early as January.

But the Fed knows that we are not out of the woods on inflation, and will wait as long as they can before they cut rates. Of course, their mythical “comfort level” for inflation, which has been exceeded for three years straight, will not prevent them from cutting rates and printing money if they see a recession or deflation coming.

Since the mid-1990s, the Fed has systematically weakened the dollar, and a weak dollar means the prices of real assets — real estate, gold, silver, timber, corporations and so on — must go up to keep international prices comparable. So a weak dollar boosts all asset prices, and when the Fed starts cutting rates again, the current dollar weakness will look like child’s play. If the Fed stays on its present course, in 25 years the average suburban home will sell for $30 million. That’s one reason I think a major down leg is coming in 2010 to 2012, to force the Fed to change their unstated policy of dollar destruction. But it looks to me like there is enough wiggle room for one more big run up before the day of reckoning arrives.

This is a difficult, tricky and accident-prone environment, and I think we should stay cautious until we see either a market breakdown or a decisive market breakout that tells us the 2007 to 2008 bull market is underway, with no more big breakdowns left to threaten our capital.

Finally, my family and my team at Phillips would like to thank the Greatest Generation one more time for the long war they fought for freedom, starting 65 years ago today. My father’s brother was on the Arizona, and my dad enlisted the next day. He was around to see me born a few weeks later, and then off with millions of others to a four-year war that truly saved the world. Thanks to all of them.