The S&P 500 finished the second quarter of 2006 with a drop of 1.44 %; the first quarterly decline after 4 consecutive positive quarterly performances for the index. This quarter would have been far worse had it not been for a strong rally in the last week of June. For the year, the S&P 500 is up 2.71% with the Energy and Utilities components advancing 12.78% and 11.78% respectively while Information Technology and Healthcare led the losing components with a drop of 6.17% and 4.57% so far this year. The stock market plunge in May was so wide ranging that every component of the S&P 500 closed the month in the red with the exception of the Consumer Staples component which closed the month pretty much unchanged. June started off not much better but the market bottomed midway in the month and rebounded in the last two weeks of the quarter.

Overdue Correction
We view the market decline in May and June as a healthy, overdue and overdone correction. The S&P 500 has been on a steady, albeit slow, advance since mid October of 2005.  From about mid October 2005 to early May 2006 the S&P steadily increased about 13% with no meaningful correction. In fact, May ’06 is the first monthly decline in the S&P since October of 2005. The correction that we have witnessed from early May to mid June of 2006 wiped out around 8 % off the S&P 500 or about 60% of the 13% gain from October to May. This seems to be a pretty harsh correction but we attribute this to the great deal of uncertainty that surrounded the June FOMC meeting and our view that the market tried to discount a worst case scenario. The dovish tone of the Fed’s June statement and the subsequent stock market rally reinforced our view.

Correction not a Bear Market
While a Federal Funds rate of 5.25% poses a higher hurdle rate for the stock market, both GDP and corporate earnings growth continue to be healthy. While GDP growth is expected to slow down for the rest of the year compared to its rapid first quarter growth of 5.6 % (a fact acknowledged in the latest FOMC release) it is still expected to show a pretty solid advance for the year of about 3.6 % according to the White House Council of Economic Advisors. As for earnings growth, according to Standard and Poor’s, 2006 S&P 500 operating earnings are expected to grow by 12.15% from 2005 levels. That is on top of 13% growth achieved in 2005 from 2004 levels. The absence of any widespread earnings warnings thus far bodes well for anticipated second quarter earnings that are about to be released in the next few weeks. Given the above facts and estimates, and the current price level of the S&P 500, we conclude that the market is discounting a potential negative third quarter earnings guidance, which is the only dark cloud that we might see ahead. We believe that 3^rd quarter guidance will be in line with estimates and this will be an additional boost for the market going forward.

Unusual Surge in Short Interest
Looking over the monthly short interest data from both the NYSE and NASDAQ, one can’t help but notice the surge in short interest for the reported period of June. For the NYSE, the June numbers show a 5.5% increase from May and for NASDAQ, June showed a whopping 11.4% increase from May. Moreover, compared to the previous 12 month average, June short interest levels for the NYSE showed a 7 % increase and for the NASDAQ a monstrous 20% jump. Not coincidently, after peaking in October and November of 2005 (previous market bottom before the latest market rally) short interest on both the NYSE and NASDAQ bottomed out in February of this year and started to slowly increase in March and April and made a spectacular increase in June. As mentioned above, provided that third quarter earnings guidance is in line with expectations and barring any unforeseen event, this level of short interest will provide ample ammunition for a decent rally in the third quarter for the market in general and for the NASDAQ in particular.

While we mentioned in our previous commentary that we were turning defensive in anticipation of uncertainty in the back half of the year, we believe that we witnessed the bulk of the uncertainty manifest itself in the May-June decline. Thus, we are turning more positive for the rest of the year and we continue to believe that the S&P 500 will achieve a high single digit return for the year. We continue to overweight or add to Technology, gold, and health care. Also, we continue to avoid oil in favor of natural gas and we are starting to reduce industrials.