Earnings: A Clearer Picture Emerges

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Finally, many of the companies in this group have large international sales components that help offset domestic weakness. S&P's forecast of a weaker U.S dollar in 2008 should continue to offer a currency conversion tailwind.

Energy earnings are expected to come in a bit weaker than the overall market. We see prices for the benchmark grade of West Texas Intermediate crude oil averaging $78.45 per barrel in 2008 and $74.33 in 2009 as a result of increased supplies from international projects coming on stream, combined with softening global demand due to seasonal factors and concerns that high prices will erode demand. By comparison, we see natural gas averaging $7.80 per million BTUs in 2008 and $8.50 in 2009. The U.S. natural gas market has tightened as a result of cold weather and lower LNG imports due to increased international competition.

The S&P 1500 Health Care sector should see a 15.4% increase in operating earnings in 2008, following a 16.5% advance in 2007. Double-digit increases are anticipated for all 10 subindustries, with the greatest growth expected to come from Health Care Facilities (+30%), Health Care Supplies (+29%) and Biotechnology (+27%). Pharmaceuticals, the largest subindustry in the group, representing 47% of the sector's weighting, is projected to post an 11% increase in operating results in 2008. Key concerns for pharmaceuticals, in our view, include research and development productivity issues, pipeline failures, greater FDA scrutiny into clinical trials, and projected flat volume under the U.S. Government's Medicare Part D prescription drug subsidy program.

Earnings in the Financials sector are not expected to recover until at least the second half of this year as we think the subprime problems will continue to spread. We think loan growth may slow as the economy cools, and cost-cutting and fee revenue will not be able to compensate for poor banking results. We see the possibility of larger banks being forced to hold leveraged loans on their balance sheets due to lack of interest from prospective buyers. They may later be forced to sell these loans at a loss to get them off the balance sheets. As a result, more companies may cut their dividends as capital positions deteriorate.

We expect further writedowns in the quarters ahead in Investment Banking & Brokerage. Although holdings of exotic securities have largely been written down, many of these banks still hold a sizeable book of non-subprime residential and commercial mortgages. Investment banking volume has slowed significantly, while mergers and acquisitions announced volume has declined precipitously as credit markets dried up in August. Debt underwriting volume is expected to be down quite a bit from lack of demand, and equity IPO (initial public offering) volume will likely remain low. We think the large financial adviser businesses should still post solid year-over-year numbers, and provide the most operational diversification. Smaller, boutique firms, however, will likely post volatile results.

The Life Insurance subindustry remains very competitive, which is holding down profit margins. Another headwind for the industry is the low interest-rate environment. We believe that variable annuity sales will increase in 2008, driven by the popularity of guaranteed living benefit riders and demographic needs. However we expect assets under management and fee income to decrease in 2008, reflecting the volatility in the equity markets. We believe that pricing pressure will act as a major headwind for the Insurance Broker subindustry in 2008. We anticipate that the softening of prices, coupled with increased competition, will fuel increased acquisition activity in 2008 as brokers look to improve their top line.

We expect difficult operating earnings comparisons in 2008 in the property-casualty subsector, reflecting competitive pricing pressures and the absence of some positive prior-year loss developments. Net investment income, once a key source of revenue growth, will also be pressured in 2008, thanks to a more challenging investment environment.