Stocks rose in heavy trading Friday, giving the S&P 500 and Dow their third up month in a row for the first time since late 2001, after a report showing surprisingly strong manufacturing growth in the U.S. Midwest fueled investor optimism.

The blue-chip Dow Jones industrial average (search) jumped 139.08 points, or 1.60 percent, to 8,850.26, its highest close this year. The tech-loaded Nasdaq composite (search) rose 20.96 points, or 1.33 percent, to 1,595.91, ending at its highest level in a year. The Standard & Poor's 500 (search) climbed 13.95 points, or 1.47 percent, to 963.59, its highest close since early July.

For May, the Dow rose 4.4 percent, the S&P 5.10 percent and the Nasdaq 8.99 percent.

"The market continues to forecast better economic conditions again, and the feeling is that you have to be long stocks," said Peter Cardillo, chief strategist and director of research at Global Partners Securities.

Traders said sentiment was also boosted after news the government lowered its terror threat level back to yellow, or "elevated," just 10 days after raising it to the second-highest level of orange, or "high."

Business expanded in Midwestern states in May for the first time since February, according to the National Association of Purchasing Management-Chicago index, suggesting improvement in the manufacturing sector as well as for the broader economy.

The report, regarded as a precursor to a national manufacturing report due on Monday, added fuel to the rally which has lifted the Nasdaq, S&P 500 and Dow about 25 percent, 20 percent and 17 percent, respectively, since mid-March.

"The Chicago Purchasing Managers number is very encouraging because it confirms the postwar economic bounce (after the Iraq war) that the market is counting on to sustain this rally," said Milton Ezrati, senior economic strategist at Lord Abbett & Co.

The last time the Nasdaq notched four straight months of gains was in 1999, when it rose for five months from August to December, according to Markethistory.com. For the Dow and S&P, the last time each index posted three straight months of gains was from October-December 2001.

Thirteen shares rose for every 4 that fell on the New York Stock Exchange and the ratio was about 11 to 5 on Nasdaq. Some 1.68 billion shares changed hands on the NYSE and 2.26 billion on Nasdaq. It was the Nasdaq's heaviest trading session of the year.

A settlement in a long-running dispute between AOL Time Warner Inc. (AOL) and Microsoft Corp. (MSFT) also boosted the market. AOL rose 37 cents, or 2.5 percent, to $15.22. Microsoft headed 21 cents higher to $24.61.

ImClone Systems Inc. (IMCL) surged $5.04, or 21.5 percent, to $28.50. Shares rallied as investors looked ahead to a meeting where scientists will present data expected to be very positive about Erbitux, its experimental cancer drug.

Halliburton (HAL) rose 72 cents to $23.87 after the company said Friday it agreed to settle shareholder lawsuits alleging the company employed accounting trickery to inflate its revenues. The company said the settlement would not have a material impact on its earnings.

McData Corp. (MCDT) jumped $2.39, or 21.6 percent, to $13.47. The company, which makes switches and software for storage networks, reported a quarterly profit versus a year-earlier loss. Among rivals, Brocade Communications Systems Inc. surged 5.7 percent, or 33 cents, to $6.11.

Helping other semiconductor stocks, Nvidia Corp. (NVDA) surged $1.96, or 8 percent, to $26.17 after UBS Warburg upgraded the chip designer to "buy" from "reduce". The Philadelphia semiconductor index rose 1.86 percent.

Meanwhile, U.S. consumer sentiment rose for the second straight month in May as rising U.S. stock markets lifted consumer spirits, overshadowing a dismal jobs market, while Iraq war concerns faded.

The University of Michigan's closely watched gauge of consumer confidence rose to 92.1 in May, its highest level in nearly a year, from April's 86.0, but slightly below economists' forecasts for a final reading of 92.6.

The Commerce Department reported that consumer spending dipped by 0.1 percent in April. That is the largest drop since the start of the year and is a sharp reversal from March when consumers increased their spending by 0.8 percent. Economists had forecast a rise of 0.1 percent for April.

Also Friday, the government reported that the incomes of Americans were unchanged in April after a gain of 0.4 percent in the previous month, a sign of the weak job market.

The Russell 2000 index, which tracks smaller company stocks, rose 8.37, or 1.9 percent, to 441.01.

Overseas, Japan's Nikkei stock average rose 0.6 percent. In Europe, Germany's DAX index rose 2.6 percent, Britain's FTSE 100 fell 0.9 percent, and France's CAC-40 increased 0.8 percent.

Reuters and the Associated Press contributed to this report.