Equityletter 10/16/06

I. Events to Watch In the Week Ahead

Here comes the third quarter earnings parade. This week we have eleven of the Dow 30 components reporting third quarter earnings. (CAT, HON, IBM, INTC, JNJ, JPM, KO, MCD, MMM, MRK, UTX) With the Dow Jones Industrial average closing at all-time highs in this past week, it can be safely stated that expectations appear to be a tad ebullient. That being said, in-line earnings reports coupled with in-line forward guidance will likely not be tolerated well. The price action of General Electric (GE) last Friday is a good example of what I am trying to express. On Wall Street, it’s all about the EXPECTATIONS. Suffice to say that this week will be a good test of the Large-cap leadership that the stock market has enjoyed over the past eleven weeks.

The Economic calendar this week will be dominated by inflation data. Tuesday morning we have the Producer Price Index (PPI), recent consensus estimates are for a drop of -0.6 %, with core PPI estimated to have risen by 0.2%. On Wednesday morning we get the Consumer Price Index (CPI), estimates here are for a drop of -0.3% with a core CPI of +0.2%.

Also, be alerted that this week is an option expiration week. Look for volatility to increase substantially from recent subdued levels.

II. General Market Overview

The past months advance in the stock market has been driven by the financial and retail sectors. The brokerage group, led by Goldman Sachs (GS) and Morgan Stanley (MS) appears to have attracted the “momentum players”. It is interesting to note that a profit warning last week from second tier brokerage firm Legg Mason (LM,) only derailed the brokerage momentum for about an hour. Also, the news that Bank America would introduce “free commissions” for certain accounts failed to send the XBD (brokerage index), in to a tailspin. Be wary of this sector, it is extended and is ignoring negative news. While the charts do not show it yet, a short term top could be close at hand.

The other area of the financial sector, the banks, have also enjoyed a recent upturn. This week will bring earnings reports from Bank America (BAC), Citibank (C), Wells Fargo (WFC), J.P. Morgan (JPM), Washington Mutual (WM) and State Street Bank (STT). We will be watching the reactions of these stocks closely, for as we have previously stated, EXPECTATIONS appear to be ahead of themselves.

We are of the opinion that it is now time to play contrarian. It is time to scale back on the financial sector and begin to accumulate (on weakness) the energy and metals sectors.

III. GOLD

GLD (streetTracks gold index) – In our 10-1-06 letter we announced our change of opinion regarding Gold. We said to cover all short positions and look to institute a long position around the $58.00 level using the GLD (gold index fund) as our trading vehicle. On

10-04-06 we went long the GLD on the close of trading at $56.37. Our protective sell-stop is 54.80. The intermediate term price objective is $65.00.

IV. Energy

In our 10-01-06 report we stated that the demise of the hedge fund Amaranth Partners, once revealed to the general public, had all the markings of creating a bottom. I believe we mentioned a possible short squeeze set-up. After a successful test of the recent lows on

10-04-06, this appears to be the case. The XOI (Amex Oil Index) has appreciated by 10% off intraday 10-04-06 lows in eight trading days. The OIH (Oil Service Holders Trust) has increased 8% and the XNG (Natural Gas Index ) by 8% as well. We continue to like this area of the market but would now like to focus on the Oil Service sector. This week Schlumberger Ltd. (SLB) reports 3^rd quarter earnings. A strong report here might be just the catalyst to ignite the OIH (127.85) from its four month slumber. Other stocks within this group that we like for a trade are Halliburton (HAL-$28.71) and ENSCO International (ESV- 44.19). Does this mean run out and buy them at the market? NO NO and NO!! Look for breaks in the market and accumulate your position.

V. Dow 30 Analysis

A new addition to Equity Letter will be a weekly analysis of the components of the Dow Jones Industrial Average (DJI). Our Weekly Trend Indicator (WTI) measures in at +5.00. This is a very strong number, so strong, that it screams short term overbought. While we are very familiar with the term, “the trend is your friend”, we feel it is time to throw up a near term caution flag. Using DIA-119.64 (Dow Industrial Diamonds) as our trading vehicle, the risk here looks to be on the downside. A weekly close below 117.91 on the DIA will set off warning signals.

Dow 30 stocks with positive weekly trends:

AIG, AXP, BA, C, CAT, DD, DIS, GE, HD, HON, HPQ, IBM, INTC, JPM, MCD, MMM, MRK, MSFT, PG, T, UTX, VZ, WMT, XOM

Dow 30 stocks with negative weekly trends:

AA, GM, JNJ, KO, MO, PFE

VI. OPEN POSITIONS

UNH- short execution-10-06-06, price 51.80 (buy stop 53.10 ) price objective 44.

GLD- long execution- 10-04-06, price 56.37 (sell stop 54.80) Price objective 65.00

XLU- short execution-9/27/06, price 34.25 (buy stop 35.20) Price objective 32.50

GM- short execution-9/28/06, price 32.90 (buy stop 34.30) Price objective 26.00

CLOSED POSITIONS

WAG (Walgreens) (1.0%)

JNJ stopped out 10-02-06 (1.7%)

* The following information has been provided for informational purposes only and should not be used or construed as an offer to sell, a solicitation, or an offer to buy, or a recommendation for any security. EquityLetter does not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regard to the results obtained from its use.