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hiker

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Market Insight for September 20, 2006

BOTH CAN'T BE RIGHT
By Sam Stovall, S&P Chief Investment Strategist
Either Wall Street's earnings growth expectations are too optimistic or S&P's economic projections are too pessimistic.

S&P Equity Research expects operating earnings for companies in the S&P 500 to increase by an average of 13% in 2006 — the fifth consecutive year of double-digit earnings gains for the S&P 500. What's more, S&P analysts expect that by the end of this year, the "500" will have recorded its 19th straight quarter of double-digit year-over-year earnings advances.

And the party looks set to roll on into 2007, provided you believe Wall Street's consensus for quarterly earnings estimates. The Street expects earnings to rise another 12% in 2007, and sees double-digit growth in each of the four quarters of the coming year. (S&P analysts will offer 2007 quarterly estimates after this year's third-quarter results are in.)

Support for these rosy forecasts is derived from factors like the beneficial effect of share buybacks, lower depreciation charges following the past few years of stagnant capital expenditures, and wider net margins, largely from lower net interest expense, as companies have reduced their borrowing for capital improvements. And the projected weakening of the U.S. dollar in 2007 could act as a tailwind.

S&P Equity Strategy isn't buying it. Shocking as it sounds, the Street's optimism is very likely misplaced. S&P Economics projects that U.S. real gross domestic product (GDP) will climb 3.5% in 2006. This is a fairly healthy advance for an economic expansion that, by the end of the year, will have passed the average duration of all postwar economic expansions. For 2007, however, S&P sees real GDP advancing only 2.1% as a result of the Fed's 17 successive 25-basis-point rate increases and the effect of oil prices. A barrel of oil is expected to average $71.40 in 2006 and $76.25 in 2007.

If S&P 500 earnings are likely to advance 13% in 2006 on a 3.5% rise in U.S. GDP, how can they climb another 12% in 2007, when real GDP is projected to rise only 2.1%? The answer is, it probably won't happen. In fact, S&P Economics' top-down estimate of S&P 500 operating earnings growth calls for only a 3% rise in 2007 — a far cry from Wall Street's bottom-up call for a 12% increase. S&P Equity Strategy believes actual results will land somewhere in between these estimates.

The ratio of S&P 500 operating earnings to nominal GDP is now more than one standard deviation above the average since 1988 (see chart). In order for this ratio to return to a more normal level, either actual earnings growth will have to be lower than projected and/or U.S. economic growth will need to be healthier than currently anticipated — which might just cause the Fed to continue to raise short-term interest rates. Either way, in the not-so-distant future, the Street may not be whistling as optimistic a tune as it is today.

To this end, S&P's Investment Policy Committee reduced the recommended allocation to U.S. stocks to 40%, moving 5% into cash. We also adjusted our Model ETF Portfolio (see cover table). The change embraces a more traditional 60% equities/40% fixed-income balance. Our S&P 500 year-end target prices of 1315 for 2006 and 1440 for 2007 remain in place. We believe the recent stock market rally has been fueled, in part, by sharply lower oil prices. Yet as oil prices near the bottom of their trading range and the S&P 500 closes in on the top of its nine-month range, a recovery, or even a counter-trend rally in oil prices on revived geopolitical concerns, could reverse the recent equity euphoria.


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Market Insight for September 26, 2006

INVESTING AT AN INFLECTION POINT
By Sam Stovall, S&P Chief Investment Strategist
In the current climate, seek out quality and yield.

Few investors were surprised on Wednesday, when Fed Chairman Ben Bernanke decided to leave short-term interest rates unchanged at 5.25%.

Although recent inflation data have been benign, the overall economic picture is far from clear. Nevertheless, S&P Economics believes the Fed is through tightening, and we look for the first rate decrease by the middle of 2007, as members of the Fed collect more data suggesting that economic growth is slowing.

S&P Equity Strategy advises emphasizing high-quality stocks and/or those that offer solid dividend yields.

There have been eight interest rate plateaus — periods between the last rate hike and the first rate cut — since 1974, each lasting seven months, on average. During the plateau periods, the S&P 500 index has gained an average of 3%, rising four times and falling four times.

But how have the individual sectors fared? S&P Equity Strategy studied each of the eight periods to determine how industries within each sector performed on an evenly weighted basis.

This analysis shows that the sectors that have gains outpacing those of the S&P 500 — and that post those gains more than half of the time — are consumer staples, financial services, health care, telecommunications, and utilities. Not surprisingly, these are the sectors that boast either a large number of high-quality names or stocks that have substantial dividend yields, or both.

Of course, S&P Equity Strategy does not only consider historical performance when making sector recommendations. After all, as we often note, "Past performance is no guarantee of future results." We also consider market fundamentals, the economic outlook, and technical factors.


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Market Insight for October 10, 2006

WHAT GOES AROUND…
By Mark Arbeter, S&P Chief Technical Strategist
Market rotation is keeping this aging bull alive and giving traders some outsized opportunities.

In the real estate market, it's location, location, location. In the stock market, it's rotation, rotation, rotation.

We believe that one of the important keys to a bull market's staying power is stock rotation, or as of late, sector rotation. Simply put, rotation is selling out of one stock or sector and putting the funds right back into another stock or sector. The key is that money stays in the market, keeping a floor under share prices. Major corrections and bear markets typically occur when investors rotate out of stocks and move to the sidelines, actually pulling money out of stocks altogether. In our view, the rotational force has led to gradually higher stock prices over the past couple of years, without a major correction along the way. In addition, it has given nimble investors a chance to capitalize by moving from sector to sector.

S&P believes the proliferation of hedge funds and exchange-traded funds has had a lot to do with these rapid rotations from sector to sector. The stock market has seen corrections within sectors over the past six months, but we think as long as money slides back and forth in the stock market, the overall downside potential should be limited.

We have seen two types of rotation this year, but to some degree, they are related. The first was a shift to large-cap stocks from mid-cap and small-cap stocks. Along with this move, there was a shift to high-quality issues from low-quality issues. Within this longer-term shift, we have seen rapid, shorter-term shifts based on the direction or forecasts for energy prices, as well as on expectations for the economy.

When technology stocks peaked in April, and consumer discretionary and small- and mid-cap stocks topped out in May, money rotated into defensive issues, which are typically large-cap stocks. Following the market bottoms in June and July, money came rushing out of energy and transportation stocks and poured back into technology and consumer discretionary stocks.

To illustrate these rapid rotations, we will first look at the driving force behind these moves: energy prices. After peaking at $77.03 a barrel on July 14, crude oil futures plunged 21.5% to $60.46 by September 20. The S&P energy sector index peaked in early August and was off 12.1% by September 20. While funds were flowing out of energy-related investments, two sectors in particular benefited. The S&P consumer discretionary index, which represents the sector most likely to gain from falling oil prices, jumped 12.1% from July 21 to September 28. The biggest beneficiary of oil's decline, however, was the S&P information technology index, which soared 17.2% in the same period. While the probability of catching an entire move like this is rather low, it is clear that there are opportunities to profit from these time-compressed moves.

With crude oil prices at long-term support levels, and extremely oversold in our view, we believe there could be a rally in energy stocks and a subsequent unwinding of the upturn in consumer discretionary and IT.


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Market Insight for October 17, 2006

HAPPY BIRTHDAY, BULL
By Sam Stovall, S&P Chief Investment Strategist
October 10th marked the fourth birthday of the current bull market.

On October 9, 2002, the S&P 500 index posted a closing low of 776.76, marking the end of a bear market that had erased 49% of the benchmark's value since beginning on March 24, 2000.

The S&P 500 received official bull market status on May 9, 2003, when it closed at 933.41, more than 20% above the October 9 close. (Standard & Poor's defines a bull market as an advance of at least 20% from the low set during the prior bear market.) Today the S&P 500 is 75.5% higher than it was on October 9, 2002. Yet this milestone, while certainly positive, raises a few questions. For example, how does this bull market stack up with prior bull markets, and how much longer does this bull have to run?

By S&P's definition, there have been 10 bull markets for the S&P 500 since 1942, excluding this current bull run, that averaged 56 months in length, or about 4.4 years (see table). Now that the current bull market has chalked up 48 months, it may be surprising to some that six of the prior 10 bull markets lasted longer. The bull market of 1990-2000 was the longest, at more than twice the average duration.

It should be encouraging to people who constantly worry about investing at the top of a bull market that after one year of a new bull market, an average 86% of the prior bear market's decline is recovered. It may also be surprising to learn that, on average, all of the prior bear market's decline, and then some, is recovered by the second year of the new bull market. The bull markets of 1942, 1974, and 2002, which followed bear market declines of more than 45%, are the exceptions.

Even though past performance is no guarantee of future results, it doesn't hurt to have an understanding of prior bull market behavior. During the first 12 months of each new bull market since 1942, the S&P 500 posted an average increase of 37.9%. What's more, none of the industries in the S&P 500 posted an average decline during first-year bulls from 1968 to 2003. Second-year bull markets have also been pretty good to investors, since the S&P 500 increased by an average 11.6% and recorded no declines, even with first-year increases of 23% to 58%.

Third-year bull markets have been the most challenging for investors and have frequently signaled the end of easy money. In the past 60 years, the average price advance was 3.6% during the third year of a bull market. More important, however, was that six of the third-year performances were disappointing to investors: one year the S&P 500 posted no change, and it declined five times. Of those five declines, three became official bear markets shortly thereafter.

But if a bull market enters into its fourth year, consider this demographic factoid: If people live to the age of 65, they have a great chance of making it to 85. And the same holds true for the seven bull markets that entered a fourth year. Six of them went on to celebrate their fourth birthday, with the only decline coming in at less than 3%. What's more, the S&P 500 typically caught a second wind during the fourth year, as demonstrated by its 13.6% average gain.

Historically, in the fifth year, the S&P 500 has either quickly lost steam — as in 1946 and 1961 — or marched on to a healthy return of more than 7%. The question is whether this fifth year will see a single-digit advance or begin a correction early in the new year. S&P is forecasting another single-digit price climb for the S&P 500 in 2007.

S&P's Investment Policy Committee sees the S&P 500 closing 2006 at 1350, an 8.2% price gain from 2005's close of 1248. We see the "500" ending 2007 at 1450, a 7.4% rise from our year-end 2005 target. Our expectation that the Fed has finished raising rates for this tightening cycle, and that the beginning of an easing cycle may emerge during the second half of 2007, fuels our optimism.

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Market Insight for November 7, 2006

PREFERABLY, IT'S ALL OR NOTHING
By Sam Stovall, S&P Chief Investment Strategist
Historically, stock prices have performed best under a unified Congress — of either party.

The mid-term elections are upon us. Control of the Senate and House of Representatives is up for grabs. Even though the Democrats may take control of the House, the odds are long for a total sweep. But as Harry Truman proved in 1948, anything is possible.

Currently, the Republicans control both the executive and legislative branches of the U.S. government. So the obvious question is: What happened to stock prices when one party surrendered partial or total control of Congress? This scenario has occurred six times since 1945 — twice to Democratic presidents and four times to Republican chief executives. Interestingly, Wall Street responded favorably to the change, with the S&P 500 posting an average price advance of 4.8% during November and December of those years (five of the six times, the S&P 500 had a gain for the year). Remember, however, that what worked in the past may not work again in the future.

So, what can investors expect in 2007?

Next year marks the third year of President Bush's second term in office. Historically, stock prices have posted their best performances in the third year of the presidential cycle, rising an average of 18% since 1945 vs. an average of 9% for all four years. What's more, third-year advances have been very consistent, as the S&P 500 climbed 93% of the time (the market was flat in 1947). The last time the "500" declined in the third year was 1939. The fourth year's 8.6% average increase is second highest.

One reason for this stellar performance could be that Wall Street anticipates that the party holding the presidency will attempt to maintain it by introducing economically stimulative legislation in the third year that will spur growth. Such action could put additional dollars into voters' pockets just as the fourth year's Election Day rolls around.

The table on the cover offers a better feel for the market's performances under different political scenarios — political unity (presidency and both houses of Congress controlled by the same party), partial gridlock (Senate or House of a different party), or total gridlock (both houses of Congress controlled by the opposite party of the president). Also shown is the S&P 500's performances under these scenarios during a third term in office and during a Republican presidency.

The S&P 500 posted better returns (and frequency of advance) during periods of political unity, but surprisingly strong results under the total gridlock scenario. The periods of partial gridlock, which were relatively rare, saw the weakest market returns on average.

When Republicans controlled the presidency, Wall Street favored political unity over total gridlock by a more than a two-to-one margin. Of course, total gridlock has occurred much more frequently.

There are not enough third years of Republican presidencies, let alone third years of second terms, to make the results statistically convincing.

Since the stock market has performed well during periods of both political unity and total gridlock, the conclusion we draw is that either Wall Street doesn't care who is running the government, instead focusing more on the Fed and fundamentals, or it dislikes disunity and would prefer to see a unified Congress — regardless of the party.


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Market Insight for November 14, 2006

STEALING FROM SANTA?
By Sam Stovall, S&P Chief Investment Strategist
Will this year's off-season market strength lead to a subdued Santa Claus rally? We don't think so.

Forecasting can be a tough business — particularly when it's about the future. Many analysts thought the third quarter would be particularly challenging for investors. Share prices are usually weak during the summer. Capital flows are also on vacation, with 401(k) and pension contributions, and any tax refund reinvestment, having already occurred. In addition, analysts typically reduce their full-year earnings estimates for the third quarter, making September the year's worst performer. And October has established itself historically as a month in which the market bottoms out. What's more, the second and third quarters of mid-term election years have been more than just challenging. Since 1945, they have declined an average of about 1% each.

This year, however, while the S&P 500 posted nearly an 8% decline during the second quarter, and retested the June 13 low during the third quarter, the market took off in August after the Fed stopped its 24-month campaign to slow economic growth. Further fuel was added to this stock market rocket when oil prices declined from $79 per barrel to under $60, and an economic soft landing in 2007 — not a recession, as hinted at by the inverted yield curve — became the increasingly accepted scenario. Finally, favorable seasonal patterns also added to investor optimism.

But have share prices gone too far? As seen in the table below, in all years since 1945, the S&P 500 typically posted a flat return in August, declined in September, and recovered in October after bottoming out. But this year, the S&P 500 gained 2.1% in August, picked up a little speed in September to clock a 2.5% advance, and then stepped on the gas for an increase of 3.2% in October. This unusually strong sequential performance has led to the obvious question: Will returns in November and December — two typically strong months of the year that have posted an average two-month advance of 3.2% since 1945 — be subdued as a result of stronger-than-average results in the August-through-October period? In other words, have we been stealing returns from the traditional end-of-year Santa Claus rally? Not according to history.

Momentum appears to be the key. Investors have witnessed a "string of strength" — positive performances in August, September, and October, which are usually periods of market weakness or heightened volatility — 10 times since World War II. In eight of these 10 times, the S&P went on to post an above-average return in the final two months of the year. The average two-month return for all 10 cases exceeded the average performance for all years by 1.3 percentage points. In the two times that the S&P 500 underperformed the average for all years, it was either flat or slightly higher, but in no case was a decline recorded. Moreover, five times the market didn't stop to catch its breath by digesting some of the prior advances with a decline in either November or December.

How far is far enough? Applying the average 4.5% two-month advance to the S&P 500's October 31 close of 1378 gives us an end-of-year value of 1440. For the Dow Jones industrial average, a 4.5% increase to its third-quarter close of 12,081 gives us an end-of-year value of 12,625. S&P's Investment Policy Committee believes that might be too ambitious. The committee raised its year-end 2006 target for the S&P 500 to 1390 from 1350, and our 2007 target to 1500 from 1450, citing the increased likelihood of an economic soft landing, stronger-than-expected earnings growth, and favorable seasonal factors.

Even though past performance does not guarantee future results, any end-of-year rally is not a bad gift for an aging bull market that recently celebrated its fourth birthday.


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Market Insight for November 21, 2006

WORLD WON'T SNIFFLE IF U.S. SNEEZES
By Alec Young, S&P Global Equity Strategist
Local demand drives global "decoupling."

International equities have outpaced U.S. stocks over the past four years. And barring some year-end meltdown, the trend looks set to continue in 2006. This year through November 10, the S&P 500 was up 10.6% — a respectable, even praiseworthy number — but quite short of the 17.8% advance (in U.S. dollars) over the same period that was posted by the MSCI EAFE index, the leading benchmark for international developed equities. Moreover, the MSCI Emerging Markets index was up 19.3%.

What is causing this outperformance — and can it continue?

Some of the strength can be attributed to a weaker U.S. dollar, attractive equity valuations, and healthy profit margins, helped by ample global liquidity and corporate restructurings induced by M&A activity. But there's another key factor at work; namely, the rest of the world is beginning to look more like the United States.

America's robust gross domestic product (GDP) growth over the past few years has been fueled largely by consumers' appetite for everything from iPods to hybrid autos to home refurbishments. But as American spenders are tightening their purse strings, falling unemployment in developed countries is causing German, French, and Japanese consumers to loosen theirs.

More significantly, rising per capita income in emerging markets — which, according to the International Monetary Fund, account for 27% of global GDP — is dramatically increasing emerging middle-class demand for such things as autos, branded apparel, home appliances, packaged goods, and consumer electronics. This trend extends beyond products, however, and as employment rates and disposable income rise, consumers are demanding access to financial services and health care as well.

This growth in domestic consumer demand in Europe, Japan, China, India, Latin America, and Eastern Europe lessens the reliance of those economies on the American consumer, thereby allowing them to "decouple" from the United Sates and better weather a U.S. slowdown.

As a result of this decoupling, independent research firm Global Insight projects that an estimated 1% reduction in 2007 U.S. GDP growth should have a relatively benign effect on world economic growth (see cover chart). Specifically, the firm estimates that world GDP growth would be reduced by only 0.6%, with the impact on key international economies like the U.K., Germany, France, Japan, and China being even smaller.

While S&P expects the U.S. economy to slow from GDP growth of 3.3% in 2006 to 2.3% in 2007, we expect global growth to be much more resilient, chalking up a 3.3% advance in 2007, down only modestly from the 3.9% increase projected for 2006. S&P Equity Strategy believes that the resilience of the world economy, given the decoupling scenario, will continue to be positive for the sales and earnings of multinationals. In addition, low valuations relative to U.S. stocks, along with our expectation of continued U.S. dollar weakness in 2007, lead us to believe international equities will continue to outperform.

The Standard & Poor's global asset allocation dedicates 20% to international equities. We recommend a 15% allocation to developed foreign markets, represented by iShares MSCI EAFE (EFA), and a 5% weighting in iShares MSCI Emerging Markets (EEM).


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Market Insight for November 29, 2006

MERGER MANIA: DRIVERS & DESTINATIONS
By Sam Stovall, S&P Chief Investment Strategist
Standard & Poor's says it's not over yet.

Market participants woke Monday, November 20, to a veritable merger maelstrom.

This included Blackstone's $20 billion proposed purchase of Equity Office Properties (EOP, 48 ***) and a $25.9 billion offer by Freeport-McMoRan (FCX, 62 ****) to buy Phelps Dodge (PD, 118 ***). Taken together, more than $50 billion in deals went down, adding to the $3.1 trillion in transactions posted in the 12 months ended November 17, and nearly $7 trillion over the past three years.

What does it all mean? What is driving this activity? Who are the beneficiaries? Which sectors are likely to see the most activity, and what are the prime takeover candidates?

S&P Equity Strategy sees the M&A activity fueled in part by ample global liquidity, with receding inflation risks likely to keep rates low, and by the emergence of private equity as a potent market force. Kenneth Shea, S&P's managing director of global equity research, thinks private equity firms "will continue to apply pressure to underperforming companies."

Another factor is the abundance of cash on corporate and private equity balance sheets. Diane Vazza, S&P's managing director of fixed-income research, says, "The cash spigot should remain open. The appetite for fixed-income securities tied to M&A will remain strong, as historically low credit default risk rates, combined with the need for yield, create powerful backdrops for continued strong fixed-income issuance."

We also believe that there is an underlying faith in future worldwide economic growth and the health of individual sectors, and that equity prices are undervalued. In addition, we think companies may feel the need for expediency in making deals before the Democrats take control of both houses of Congress. What's more, the economic backdrop looks favorable, as S&P Economics does not foresee a recession in the United States in 2007. S&P is forecasting real GDP (gross domestic product) growth slowing to 2.3% next year from the 3.3% expected for 2006. In addition, we see global growth at 3.3% in 2007, down from the 3.9% estimated for 2006. We think future U.S. economic growth will be investment led, rather than consumer driven, as it was in prior years. Even though S&P sees consumer spending up a respectable 2.8% in 2007 — a result of only a modest uptick in long-term interest rates and a slight rise in the unemployment rate to an average 4.9% — we believe the industrial side of the equation will be significant, as evidenced by our projected 6.8% advance in equipment investment and 8.8% increase in non-residential construction.

The past 12 months have witnessed $3.1 trillion in M&A activity, more than 45% of the three-year total of $6.8 trillion. In the past year, more than 20% occurred in the financial services sector. Cathy Seifert, head of equity analysis for S&P's financial services group, says that going forward a number of midsize and small firms, anticipating the lagging effect of the inverted yield curve, "may seek economies of scale or diversification of business mix." The consumer discretionary and industrials sectors have also been highly active over the past year. The financial services, consumer discretionary, and industrials sectors also dominated the three-year totals.

The two primary beneficiaries of the merger trend are the investment banks doing the advising and the companies being acquired. According to S&P's Capital IQ, over the past two years, Citigroup (C, 51 *****) has advised on about $800 billion in M&A transactions, followed by Morgan Stanley (MS, 79 ***), with $754 billion in deals, and Goldman Sachs (GS, 201 *****), with $671 billion in deals.


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Market Insight for December 5, 2006

RATE CUT BUMP
By Sam Stovall, S&P Chief Investment Strategist
When interest rates fall, optimism (and stock prices) usually rise.

Nothing excites Wall Street more than the possibility of a new round of rate cuts by the Federal Reserve.

Stock market history shows that when the Fed started cutting rates, investors typically received a greater than two-for-one stock price return — in other words, more than a year's worth of stock market advances (based on the average annual gain for the S&P 500, since 1945, of 9%) in six months.

Take a look at the accompanying table, which shows price performance for the major stock and bond indices six months after the Federal Reserve started lowering interest rates. (Discount rates were analyzed from 1945 through 1982 and the Fed funds rate thereafter.) Standard & Poor's expects the Fed to make its first rate cut in the summer of 2007.

The Fed has launched 10 rate-cutting campaigns since World War II. In the six months after the first cut, the S&P 500 advanced an average of 11%, two percentage points better than the average price increase in all years since 1945. A bit surprisingly, the market did not rise in each case, as stock prices fell four out of 10 times. Not shown in the table, however, is that 12 months after the first rate cut, the S&P 500 gained an average of 18.6% and posted an increase in nine of 10 observations (lower rates were not enough to stop the market meltdown in 2001). Since 1980, the starting date for most major indices, we see that during the first six months of rate reductions, growth generally beat value, small-caps outperformed large-caps, and the cyclical groups beat them all. Finally, we note that while bonds advanced fairly consistently, they usually lagged behind equities, even as rates fell.

Digging a little deeper to the sector level, if 2007 is indeed a year when investors look beyond the mid-cycle pause in the economy to the recovery that is widely expected for 2008, they may again embrace cyclical sectors at the expense of the defensive ones.

Looking at data that shows average price performance (and frequencies of outperformance) for the underlying industries from 1945 through 1982, and S&P sector level data thereafter, we found that the strongest price performance came from the cyclical consumer discretionary, industrials, and information technology sectors. The financials, telecom services, and utilities sectors posted the smallest average advances. The highest frequency of outperformance was found in the consumer staples, industrials, and information technology sectors.

Remember, of course, that past performance is no guarantee of future results.


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Market Insight for December 12, 2006

SINGLE-DIGIT GAINS IN 2007
By Sam Stovall, S&P Chief Investment Strategist
S&P Economics thinks the risk of recession in the United States is no more than 25% in 2007, setting up the market for modest upside.

Real gross domestic product (GDP) growth should ease to 2.3% in 2007 from 3.3% estimated for 2006, but then recover slightly to 2.5% in 2008, as seen in the table below.

We think the 17 consecutive Fed funds rate increases, combined with oil prices that are twice where they were in 2000 and a slowdown in the housing market, will shave one percentage point from U.S. GDP growth in 2007. Although we would not count the consumer out, we believe economic growth in 2007 will be investment led, rather than housing led as in the past few years.

Inflation should continue to decline, owing to worldwide competition and slowing economic growth. We expect the value of the U.S. dollar to decline 4%, because the Federal Reserve has finished raising short-term rates, in our view, and slowing economic growth should cause some foreign capital to seek more potentially rewarding investment opportunities elsewhere. As a result, we see the yield on the 10-year note edging higher, ending 2007 at 5.2% and averaging 5.4% in 2008. If inflation remains benign and the employment figures begin to soften in early 2007, as we project, the Fed will likely begin easing rates by mid-year.

S&P Economics, in conjunction with research firm Global Insight, projects that oil prices will average $66.55 and about $65 in 2007. Should oil prices remain a page-three story, rather than regain headline status, we believe they will have a minimal impact on U.S. economic growth and consumer sentiment.

Fundamental Focus

Corporate earnings are on a roll. By S&P calculations, operating earnings for the S&P 500 have posted double-digit year-over-year increases in each of the past 18 quarters, with upside surprises becoming the norm. For all of 2006, S&P analysts are forecasting a 15% rise in earnings for the S&P 500 to 87.71 from 76.44 (see table below). For 2007, just as U.S. economic growth is projected to slow, so too are operating earnings — to a 9.7% gain.

During 2007, S&P analysts project that an acceleration in S&P 500 earnings growth will likely come from the information technology, telecommunication services, and health care sectors, each of which is expected to see earnings rise 50% or more above the market's projected growth rate. Subpar earnings growth is forecast for the consumer discretionary, financials, materials, energy, and consumer staples sectors.

Aiding our earnings projections for 2007 is our forecast of a 4% decline in the value of the U.S. dollar. According to S&P Index Services, 41% of the revenues for companies in the S&P 500 came from non-U.S. sources in 2005. The sectors with the greatest overseas exposure were energy (59%), information technology (56%), consumer staples and industrials (43% each), and materials, which was tied with the overall market at 41%. Telecommunication services (3%) and utilities (17%) had the smallest overseas exposure.

Despite the expected 12% advance in price for the S&P 500 in 2006, valuations don't look stretched. As of late November, the S&P 500 was trading at 16.3 times trailing 12-month operating earnings (including the nearly completed third-quarter earnings and remaining estimates), which was a 17% discount to the average P/E of 19.5 since S&P began capturing operating results in 1988. The market now is trading at 14.6 times our 2007 estimates. The current trailing P/E is a 22% discount to the 1988 average, and within spitting distance of the average P/E since 1935.

Falling Rates, Rising Prices

The Fed has launched 10 rate-cutting campaigns since World War II. In the six months after the first cut, the S&P 500 advanced an average of 11%, two percentage points better than the 12-month average price increase in all years since 1945. A bit surprisingly, the market did not rise in each case, as stock prices fell four out of 10 times. Furthermore, 12 months after the first rate cut, the S&P 500 gained an average of 18.6% and posted an increase in nine of 10 observations (lower rates were not enough to stop the market meltdown in 2001). Since 1980, the starting date for most major indices, we see that during the first six months of rate reductions, growth generally beat value, small-caps outperformed large-caps, and the cyclical groups beat them all. Finally, we note that while bonds advanced fairly consistently, they usually lagged behind equities, even as rates fell.

History, of course, is a guideline, not gospel.

Risks to Our Forecasts

There's no guarantee that what we project won't encounter headwinds. We believe the greatest risks come from the following areas: oil price spike, weaker-than-expected housing, consumer meltdown, recession, and earnings shortfall.

During the third quarter of this year, oil prices both peaked and plummeted. We think it's plausible that oil prices could re-approach the $70-per-barrel level if we see a reversal of fortunes in geopolitical tensions, weather patterns, or inventory levels.

These higher prices could exacerbate the already weakening housing numbers, either from an indirect effect on interest rates or from a direct blow to consumer confidence and spending. S&P forecasts a 4% decline in residential construction in 2006, accelerating to a 15% decline in 2007. Every recession since 1970 has been accompanied by a year-over-year decline in residential construction. The reason S&P believes a construction decline will not lead to a recession this time is the same reason it did not during the last soft landing in 1994-95. We project a slowdown in consumer spending, but not a meltdown.

If we are wrong, however, and we find that weaker housing does contribute to either a harder landing or even a recession, we believe the victim will be corporate earnings. As a result, our 2007 bottom-up earnings growth projection of 9% would likely move towards our top-down estimate of only 4%. Should that happen, however, we believe there will be no doubt that the Fed will begin a rate reduction program to re-stimulate the economy, which would then likely lead to share price recovery in the following six to 12 months.


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Market Insight for January 4, 2007

THE FATE OF THE CARRY TRADE
By Alec Young, International Equity Strategist
Concerns over its unwinding are overstated, says S&P

It’s a liquid planet, in more ways than one. Low global inflation, China’s $100 billion in foreign exchange reserves, and a growing reservoir of Middle Eastern oil dollars have created an ocean of liquidity. The result, in our view, has been increased risk tolerance, lower equity volatility, and excellent returns in higher-risk asset classes.

Most important, ample liquidity has helped keep interest rates low around the world. Among the major economies, Japan’s monetary policy — thanks to lingering concerns about deflation — is by far the most accommodative (see chart).

Bolder market participants have taken advantage of this interest rate disparity in a strategy known as the “carry trade.” An investor borrows money from a low-interest-rate country like Japan and invests it in a country where interest rates are substantially higher. Profit is obtained from the spread between the rates. In addition, a weak yen, resulting from the Bank of Japan’s reluctance to aggressively raise rates, has enhanced the carry trade’s appeal.

The outlook for Japan’s economic growth, and its impact on the Bank of Japan’s monetary policy, has far-reaching implications for global capital markets. This was evidenced last May, when global markets plunged amid concerns over growth prospects and the possibility of tighter policy from Japan’s central bank. Markets have since recovered — but the concerns remain.

Japanese interest rates are headed significantly higher, according to the naysayers. In this scenario, the wide rate spreads that have fueled the carry trade in recent years would shrink. In addition, more competitive rates would allow the yen to appreciate sharply, thereby undermining the rationale for shorting the Japanese currency.

The bears believe the potential removal of the liquidity derived from the carry trade could result in a sharp rise in volatility, as investors shun stocks in favor of lower-risk asset classes like cash.

While S&P Equity Strategy believes the yen carry trade’s popularity has probably peaked, we expect it to be unwound gradually, with limited negative repercussions for global capital markets. The reason for this is twofold. First, we are skeptical that the Bank of Japan will tighten aggressively. After a decade of falling prices, we believe Japanese interest rates will rise only gradually, as the central bank awaits further evidence of an end to deflation. In addition, we believe Japanese economic momentum is faltering somewhat, precluding a more hawkish monetary policy stance. Second, we think the expected anemic pace of rate hikes will keep the yen from appreciating too sharply or too quickly, especially given the faster pace of tightening we expect from the European Central Bank and the Bank of England.

S&P believes this is good news for global equity investors. Our global asset allocation remains unchanged with a healthy 60% equity weighting, of which 40% is domestic and 20% international. Our recommended international weighting includes 15% in developed-country stocks and 5% in emerging market equities.


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Market Insight for January 10, 2007

VOLATILITY: TOO LOW FOR TOO LONG?
By Alec Young, S&P International Equity Strategist
Rebalance; don’t retreat.

Financial markets are driven by what John Maynard Keynes called “animal spirits,” the most powerful being fear and greed. One widely tracked gauge of fear is the CBOE Volatility Index (VIX), which measures the market’s expectations for near-term volatility as conveyed by S&P 500 index option prices. Higher readings point to increased investor anxiety.

Currently, the VIX is trading at multi-year lows, suggesting that fear is in deep hibernation. But when combined with the strength in global markets over the past three years — the S&P Global 1200 is up roughly 100% since March 2003 — many market participants are concerned that the complacency implied by the VIX is spreading, leaving global stock markets vulnerable to attack by the dreaded bear.

Not likely, in the opinion of S&P Equity Strategy. We believe the reason for the complacency is less the sloth of bulls than the fact that equity fundamentals are, in a word, excellent. Liquidity is ample and inflation is low, both of which serve to depress interest rates and fuel unprecedented global M&A activity. At the same time, attractive 2007 growth prospects and low P/E-to-growth ratios are lending important valuation support to global stock markets.

In this climate, investors concerned about a spike in volatility should watch for any deterioration of these fundamentals. We do not believe, however, that such an erosion is nigh. Modest portfolio rebalancing is certainly appropriate in light of recent gains. But given the difficulty of successfully timing the market — requiring both a graceful exit at the top as well as a cool reentry at the bottom — S&P Equity Strategy does not currently advise significantly reducing equity exposure.

Global equity valuations are historically low, especially given healthy 2007 earnings expectations. Despite a consensus 2007 earnings growth projection of 9%, above the historical average, the S&P Global 1200 index is currently trading at a P/E of only 14.6, a 12% discount to its long-term average of 16.5.

We believe conservative valuations reflect fears of a U.S. economic recession, led by a collapse of the housing sector, and the potential negative impact on global growth and corporate profits. However, increasing domestic demand in Europe, Japan, and key emerging markets (which now account for 50% of global GDP growth) is creating a macroeconomic landscape wherein the world is less dependent on exports to the United States to maintain a healthy expansion. In addition, fears of a U.S. slowdown have been widely telegraphed and are now fully discounted, we believe, in valuations, both domestically and internationally. As a result, we believe consensus 2007 global GDP and profit growth estimates are achievable and should enable continued strong equity performance.

In addition, low global interest rates are supporting equity valuations by lowering both the cost of capital and the appeal of competing asset classes like fixed-income. We believe this will continue in 2007, thanks to abundant liquidity stemming from benign global inflation, historically low corporate default rates, record Chinese foreign exchange reserves, and a growing cache of petrodollars.

In conclusion, S&P recommends staying with a 60% equity allocation that dedicates 40% to U.S. stocks. Specifically, we advise 34% in large-cap, 4% in mid-cap, and 2% in small-cap issues. In addition, we advise a 20% international equity allocation, with 15% in developed markets and 5% in emerging markets. Our recommended ETF portfolio can be found at http://www.outlook.standardandpoors.com.


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Market Insight for January 23, 2007

MID-CAPS: THE UNDISCOVERED COUNTRY
By Alec Young, Equity Strategist
They’re growing faster than large-caps and are more attractively valued than small-caps.

Investors debate the relative merits of large-cap vs. small-cap stocks with the relish that baseball fans compare Joe DiMaggio and Ted Williams, oenophiles various vintages of Bordeaux, and classical music lovers the best recordings of Beethoven’s piano sonatas. This year is no exception, especially following the heady gains of the S&P 500 and S&P SmallCap 600 over the past one- and three-year periods.

For each asset class there are many arguments pro and con. But S&P Equity Strategy recommends that market participants take a good look at the mid-caps — those companies with market capitalizations of $1 billion to $4.5 billion. In addition to very competitive long-term returns, the S&P MidCap 400 index was up 0.8% this year through January 18 vs. a 0.6% gain for the S&P 500 and a 0.9% decline for the S&P SmallCap 600.

We think mid-caps represent the “sweet spot” of the U.S. equity market. Earnings growth is faster than among the large-caps, while volatility is lower, and valuations are more attractive than those of small-caps. In addition, while most institutional and retail investors already have sizable allocations in the large- and small-cap asset classes, mid-caps remain largely undiscovered, paving the way for strong money flows as this asset class draws greater investor interest.

The macroeconomic environment also favors mid-caps. Amid a slowing economy and concern about decelerating earnings, investors are likely to gravitate toward asset classes with the highest potential profit growth. We expect earnings for large- and small-cap firms to slow in 2007 — to 10% from 15% in 2006 for large-caps and to 10% from 14% for small-caps. But we see the S&P MidCap 400 posting 16% profit growth this year vs. 15% in 2006.

Mid-cap valuations look good too. S&P Equity Strategy’s favorite metric is the P/E-to-growth ratio, obtained by dividing the P/E by the projected earnings growth rate. A lower ratio reflects better relative value. While the S&P 500 index trades at a P/E-to-growth ratio of 1.5 times 2007 estimates and the S&P SmallCap 600 index trades at 1.7, the S&P 400's P/E-to-growth ratio is only 1.

In conclusion, we believe equity investors can benefit from a domestic mid-cap allocation. Mid-cap stocks represent 4% of the 40% domestic equity weighting in our current global asset allocation, equating to 10% of the overall U.S. equity allocation. But growth-oriented investors who seek long-term capital appreciation, and have time horizons of three years or more, should consider increasing their exposure to as much as 20%.

For more on mid-caps, including stock, ETF, and mutual fund recommendations, please go to page 8.


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Market Insight for January 30, 2007

THE CANCELLATION TANGO
By Sam Stovall, S&P Chief Investment Strategist
Economic pluses have been offsetting economic minuses — a pattern we expect to continue throughout 2007’s soft landing.

What a difference a few quarters make. During the first quarter of 2006, the U.S. economy posted a 5.6% year-over-year increase in real gross domestic product (GDP), a pace typically seen in the early stages of an economic recovery, not four years into a mature expansion. Consumer spending rose 4.8%, while non-residential construction (offices, hotels, highways) exploded with a 15.6% gain. In addition, exports surged 14%, dwarfing the 9% advance in imports. And even though the Federal Reserve was not finished raising short-term interest rates, headline and core inflation were rising at a modest 2.2% and 2.4% rate, respectively.

Ominous clouds were on the horizon, however. S&P’s chief economist, David Wyss, projected that residential construction, which includes new home building and home improvements, would decline 16.2% on a year-over-year basis by the end of 2006, thus accelerating the downturn in housing that started in mid-2005. In addition, even though the United States had not endured a national drop in home prices since the 1930s, S&P expected one in 2006 and 2007, with the median existing home price declining about 8%. S&P forecast that this housing drag would slow real GDP growth in 2007 by a full percentage point, to 2.3% from the 3.3% expected for all of 2006.

Yet several favorable factors appear to have offset the potential havoc that such a sharp slump in housing prices and construction levels could wreak on consumer spending and overall economic growth.

First, S&P believes that the more than $20 drop in oil prices from the upper $70s per barrel area has probably been the greatest positive. S&P estimates that for every $10 decrease in the price of oil, real U.S. GDP advances at least 0.25%, as consumer spending on non-energy items rises, thus offsetting the drop in home sales and prices.

Second, the yield on the 10-year Treasury note declined from the June 2006 high of 5.25% to below 4.5% during the second half of 2006 as bond investors worried that the U.S. economy was headed toward recession in 2007. The rate now stands at 4.8%. This interest rate moderation not only cushioned the impact of slumping home prices, but also supported retail spending during the holidays and has improved our consumer spending forecast for 2007. Finally, S&P believes a firm employment picture has helped solidify consumer confidence and the overall growth projection for the U.S. economy.

As a result of this cancellation tango — pluses offsetting minuses — S&P’s Investment Policy Committee continues to believe equities offer a better potential return than cash or bonds in 2007. We forecast the S&P 500 will close 2007 at 1510, for a near 8.5% total return, and suggest investors emphasize the cyclical sectors of the market at the expense of the more defensive ones.


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Market Insight for February 22, 2007

COULD HAVE BEEN A LOT WORSE
By Sam Stovall, S&P Chief Investment Strategist
After a rough start, the fourth quarter delivered respectable profit gains.

A steady stream of early earnings shortfalls made it appear as if the S&P 500 would post only a 6.9% increase in year-over-year operating results for the fourth quarter. Now, a 10.2% gain seems more likely.

More than 80% of the companies in the S&P 500 have reported fourth-quarter 2006 operating results. At the beginning of the period, S&P analysts expected a 9.1% year-over-year increase. At one point, however, it appeared — after high-profile misses from the likes of Dell, Alcatel-Lucent and Devon Energy — that earnings would fall far short of that mark. But just as with early exit polls during national elections, it’s best to wait until all polls close before you announce the winner.

By sector, as seen in the accompanying table, the best results — as well as notable upside surprises — came from the consumer discretionary, materials, and industrials sectors. The biggest disappointments were seen in energy, health care, and information technology.

In financials, the three sub-industries with the greatest upside surprises included the asset managers & custody banks (increased transaction volume and growth in global custody), property-casualty insurers (higher premium prices and lower catastrophe payouts), and investment banks (solid trading and M&A profits).

For industrials, positive surprises emerged from aerospace & defense (strong backlogs for commercial aircraft and integrated defense systems), office services (higher sales, stringent cost cutting, and share repurchases), and railroads (lower fuel costs and improved equipment usage velocity).

Materials standouts included construction materials (continued strength in nonresidential construction and highway spending), metal & glass containers (strong global demand for metal beverage cans and plastic containers), and steel (better-than-expected demand for flat-roll steel and a slower-than-expected rise in raw material costs).

As is usually the case, company managements offered limited information regarding profit outlooks. S&P analysts estimate earnings for the S&P 500 will advance 7.6% for the full year, down from the 9.6% forecast at the beginning of the year. Except for telecom services and utilities, there were downward revisions in excess of 10% to year-ahead estimates for the remaining eight sectors. The sharpest cuts were seen in consumer discretionary, energy, and materials. In addition, 2007 earnings projections for the S&P SmallCap 600 index, besides being cut to nearly nothing during the fourth quarter, are now expected to increase 9.6% in 2007, down from the previous estimate of 11.9% at the end of 2006.

S&P’s Investment Policy Committee forecasts a 1510 year-end 2007 value for the S&P 500, indicating 6.5% price appreciation. We advise investors to maintain a balanced approach, with 60% of holdings in equities (40% U.S., 20% international) and 40% fixed-income (25% bonds, 15% cash).


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Market Insight for March 8, 2007

THE START OF SOMETHING BIG?
By Sam Stovall, S&P Chief Investment Strategist
Opportunities are likely to emerge once the dust settles.

The 3.46% drop in the S&P 500 on February 27 was eye-catching, but it certainly was not record-setting. In fact, it was only No. 31 on the one-day “hit” parade since 1950. The first trading day’s decline after 9/11 was bigger, as was the fallout from Long-Term Capital Management’s implosion in 1998. Of course, the mother of all single-session slumps occurred on Black Monday, October 19, 1987.

What triggered the major decline? Many things, in our opinion, which essentially related to the prospects for a worldwide economic slowdown. In the United States, investors had been barraged by a battery of less-than-rosy economic reports and comments, including the current debate about the impact from submerging subprime loans; last week’s larger-than-expected rise in core consumer price index; a warning by former Fed Chairman Alan Greenspan about the possibility the U.S. economy could slip into recession by year-end; and a durable goods orders report that was substantially weaker than anticipated. Fear of a sharp revision to the preliminary fourth-quarter 2006 real GDP report was realized, as the number was lowered to 2.2% from 3.5%.

When China was added to our more parochial ponderings, investors began to worry that the legs supporting worldwide economic growth had become less stable than earlier believed. Investors are well aware of the Chinese government’s attempts to slow economic growth through interest rate increases and higher bank reserve requirements. But when the Shanghai market tumbled more than 9% on February 27, it became the tipping point for worldwide markets as investors, we think, worried that the engine of global economic growth was shifting into lower gear.

Unfazed Fundamental Forecasts

Investors shouldn’t be too surprised by the market’s sharp decline, however. The S&P 500 index posted positive performances in each of the last eight months (and was on the way to recording its ninth). This string of uninterrupted strength is less common than investors might think. What’s more, the S&P 500 had not experienced a 2% one-day decline since May 19, 2003. It enjoyed 949 days of relatively smooth sailing, which was the longest span since 1950. The second longest streak was 807 days from August 21, 1975 through October 30, 1978.

In addition, Mark Arbeter, S&P’s chief technical strategist, warned that the three major U.S. markets, as well as at least eight of the 10 S&P 500 sectors, were in severe overbought conditions, by his analysis, and that divergences were emerging. The real question now is, how long will this downturn last? In the short term, we believe the answer lies in the technical action of the market. In other words, the market will stop declining when it wants to, and we will take our cues from its near-term fluctuations. In all, Arbeter believes we could see a correction of between 5% and 7% in the S&P 500.

Longer term, however, S&P Equity Strategy believes the underpinnings for equity price advances remain intact. Our year-end forecast for the S&P 500 remains at 1510, for an expected 6.5% price gain from 2006’s closing price of 1418.30. S&P Economics is calling for a 2.4% advance in U.S. GDP this year, representing a healthy component of the 3.3% growth anticipated in worldwide GDP. S&P equity analysts are still projecting an 8% rise in S&P 500 operating earnings during 2007, and as a result of the recent decline in prices, valuations are even more attractive than before, in our opinion. Based on trailing 12-month earnings, the S&P 500 is currently trading at a 19% discount to the average P/E ratio since operating earnings were first captured by S&P. The P/E on projected 2007 earnings now stands at 14.8. From an “as reported” standpoint, the trailing P/E is at a 25% discount to the average since 1988 and the forward P/E is 30 basis points away from the average trailing P/E of 15.7 since 1935.

Abounding Opportunities?

One man’s trash is another man’s treasure. In order to unearth some treasures, we have to sift through those sectors and sub-industries that were trashed in the recent carnage. Even though all 10 sectors within the S&P Composite 1500 index (consisting of the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indices) posted declines, the levels of retreat were fairly uniform. Decreases ranged from -2.7% for the health care sector to -4.2% for the materials group. In addition, all 138 sub-industry indices posted declines on the day from -1.5% for brewers (“When the going gets tough, the tough go eating, smoking, and drinking!”) to -6.8% for steel companies.

While the long-anticipated and much-needed correction may be at hand, S&P believes that once the dust settles, a clearer array of buying opportunities may emerge.


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Market Insight for March 20, 2007

SUBPRIME SENTIMENT
By Sam Stovall, S&P Chief Investment Strategist
Amid the rubble, we see opportunities in higher-quality banks.

Only two weeks after a 3.5% one-day drop in the S&P 500, the market suffered another 2% decline, triggered by a Mortgage Bankers Association (MBA) report of an increase in subprime and prime delinquencies (see chart below) and by a weaker-than-expected retail sales report. All 10 sectors in the S&P 500 took a hit on March 13, with the S&P 500 financials sector down the most on the day (-3%), while energy held up best (-1.2%). S&P's Equity Strategy believes the sell-off was the result of investors' unfounded concerns that these reports were symptoms of bigger underlying problems, such as a drying up of global liquidity, the spreading of the subprime problem into other areas of the lending market, and the potential drag-down effect on consumer spending. The decline, in our opinion, is not likely over.

Mark Arbeter, S&P's chief technical strategist, believes the successful price test on March 14 was impressive and may have broken the back of the bears, at least in the short term. While the S&P 500 did break below March 5's closing low of 1374.12 on an intraday basis, the index reversed sharply back to the upside and traced out a candlestick known as a hammer. When these patterns occur near important support, their implications are very positive for the market. To complete a potential reversal formation or double bottom, the S&P 500 would have to take out its recent closing high of 1407. If the index can do that, the intermediate-term trend would once again be bullish.

From a technical perspective, Arbeter believes the S&P 500 financials index has broken down on an intermediate-term basis on very heavy volume, and appears headed for a test of long-term support just 1% below current prices. The index is quickly closing in on the support drawn off the lows in October 2005 and mid-2006, in the 461 area (see chart below). The sector index recently broke below nearer-term trendline support that had held up prices since mid-2006. In addition, the index sliced through its 17-week and 43-week exponential moving averages. Because the drop was so swift, the 17-week has not yet crossed below the 43-week, which would be an additional negative signal. If that moving average crossover were to occur, we would get a long-term sell signal. A break below long-term trendline support in the 461 level would set the index up for a test of chart support in the 420 to 450 range. Since the index is not yet oversold on a weekly basis, we would avoid this area.

Cathy Seifert, head of U.S. financial services equity analysis for S&P, reiterated her neutral fundamental opinion of the financials sector, while S&P Equity Strategy maintained its marketweight recommendation. Seifert acknowledged that near-term investor sentiment in this sector has been hurt by concerns that the meltdown in the subprime mortgage market may spill over into the broader mortgage and mortgage-backed securities markets, but said that longer-term opportunities may be emerging.

Frank Braden, S&P's U.S. large-cap bank equity analyst, put the MBA report into perspective by noting that even though residential mortgage delinquencies were at 4.95% at the end of 2006, delinquencies averaged 5.3% during the 1980s. He also said that many large diversified banks have already tightened their lending standards and have sought to reduce their exposure to a deteriorating mortgage market. In addition, he says, these large banks have deep pockets and a diversified revenue base that should minimize the impact of a significant downturn.

Wachovia (WB, *****), through its acquisition of Golden West Financial, has greatly increased its exposure to nontraditional products, such as option adjustable-rate mortgages, but does not originate any subprime mortgage loans, Braden says. Conversely, Wells Fargo (WFC, ***), where about 20% of mortgage originations are in the subprime space, does not offer option ARMs. Nor does it offer negative amortizing, non-prime interest-only, or non-prime low-doc or no-doc mortgages. Master List company Bank of America (BAC, *****) exited the subprime real estate lending business in 2001 and now has what we consider a high-quality home equity and residential real estate portfolio. Citigroup (C, *****), another large player in the subprime market through fixed-rate products, felt the effects of the subprime downturn through its ClearBridge Asset Management subsidiary, which held a 3.5% stake in New Century as of December 31, 2006. Citigroup reported non-prime first mortgage 30-day delinquencies of 3.6% vs. 6.5% for its peers. The company's consumer real estate lending business, both prime and subprime, accounted for about 4% of total revenues in 2006.

The financials sector offers a relatively high dividend yield and carries the second-highest overall S&P Quality Ranking by market cap within the S&P 500. As a result, Seifert recommends investors acquire four- and five-STARS stocks, many of which offer dividend yields that are twice that of the S&P 500 and rival the yield on the 10-year Treasury note. Some four- and five-STARS stocks that are large-cap with Quality Rankings of A- or better include Bank of America (Quality Ranking: A), Citigroup (A+), BB&T (BBT, A-, ****), Regions Financial (RF, A-, *****), and Wachovia (A-). Seifert adds that several sub-industries, such as the insurers, are defensive by nature, since their fortunes are not dependent on economic growth and their portfolios predominantly hold short-term debt.


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Market Insight for April 3, 2007

THE WAGES OF FEAR
By Mark Arbeter, S&P Chief Technical Strategist
Bearish sentiment suggests another run to the upside.

It's not often we predict a spike higher. That fraternity of market mavens who, among other non-bull's-eyes, have called nine of the last six recessions is just not where we'd care to be.

That said, certain technical measures we follow suggest higher prices could be in store later this year.

We're talking about the put/call ratio, which tracks options contracts purchased on the Chicago Board of Options Exchange. Puts are, of course, options to sell; calls are options to buy. The ratio is used widely as a gauge of market sentiment. When there are more calls than puts, Mr. Market is bullish. More puts than calls, and Mr. Market is bearish.

Recently (see chart) this measure hit an all-time high, suggesting Mr. Market had just taken a room at the Bates Motel — a glut of fear, in other words. Interestingly enough, this occurred during what was by historical standards a relatively modest pullback. This excessive fear is, we suggest, bullish.

Then there are odd-lot short sales. Odd lots are, of course, quantities of shares that are less than the standard 100-share block, and they are generally traded by novice investors. Short sales of odd lots indicate novices think the market is on the verge of a painful plunge. This bearishness by beginners is, likewise, bullish.

So are higher prices in store? Again, no predictions — but such a move has the potential to be significant. Owing to the swift decline in stock prices in all major U.S. stock indices during late February and early March, there is little chart resistance overhead. By resistance, we simply mean levels on the chart where previous buying took place; markets have the tendency to stall at such levels as buyers who bought at those levels sell.

The first band of resistance for the S&P 500, from a 21-day price range, comes in at 1435, right near its recent rally point. Above that, the only real chart resistance is around the February recovery highs of 1450 and 1460.

And quick moves to the downside, like the one on February 27, occur with very little demand or buying on the way down. This can be positive once the market turns around, since it is much easier to then move right back up through the range established since February 27.

So as we see it, a vacuum gets created in a price range, and the moves within this range can be very quick and unrestrained.

While we all know that bull markets trend higher and bear markets trend lower, different phases — or slopes within the longer trend — can develop. (Think of Mount Everest — the track from Base Camp to the Khumbu Icefall is a much milder angle upward than the almost vertical Hillary Step near the summit.) For instance, from March 2003 until March 2004, the slope of the S&P 500 was fairly steep at about 43 degrees. From March 2004 until July 2006, the slope was only about 18 degrees. Since the intermediate-term bottom last summer, the slope of the bull market has steepened, rising at an angle of about 34 degrees. A linear regression of the advance since last summer is actually steeper, coming in at 40 degrees. We point this out because the new slope that may be developing is young, so it is somewhat tough to measure perfectly.

The implications of a steeper intermediate-term slope are clear: big gains to the upside and potentially a mini-blowoff. We found a couple of cases in recent history that look somewhat similar to recent market action. They both occurred in the year after the four-year cycle low, which we are in now. These blowoffs also happened after a strong, low-volatility advance, such as the one from August until February. In addition, they occurred right after a mini-shakeout. The first instance was in 1995-1996, when the S&P 500 exploded up 10.5% in 23 trading days. The second example was in late 2003/early 2004 when the "500" surged 12% in 55 trading days.

A major blowoff took place in 1987. This time period, as well as the chart pattern from back then, matches up well with recent market activity. In 1986, there was a four-year cycle low in which we did not have a bear market, just like 2006. The bull market was in its fifth year, after the August 1982 bear market low. We are currently in the fifth year of a bull market. In early 1987, the S&P 500 rallied 24.5% in less than three months. This is certainly a larger gain than the present advance we've had from the summer 2006 lows, and much faster. The index then went through a fairly quick shakeout, falling 7.5% in six trading days. This is somewhat similar to what we just went through. The market then put in a double bottom, broke out, and then retested the lows. Sound at least a little familiar? The "500" then had an upside explosion, running 21% in 67 days right into the 1987 top.

Again, we note the scenario sketched out above is just that — a possible scenario based on technical observations in the past. But it's one that bears watching.


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hiker

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Market Insight for April 17, 2007

THE LOWDOWN ON Q1 EARNINGS
Double-digit growth unlikely; IPC raises international exposure.

The first-quarter earnings reporting season is now upon us. It looks to be challenging, suggesting a difficult earnings front for 2007.

Corporate profits have, until recently, been on a tear. From the second quarter of 2002 through the third period of 2006, the S&P 500 posted 18 straight quarters of double-digit increases in year-over-year operating earnings. The fourth quarter of 2006, however, slowed to an 8.9% rise, and Standard & Poor’s equity analysts don’t see another double-digit quarter until at least the end of this year.

As of the end of March, S&P equity analysts expected strong first-quarter earnings growth from the telecom services (+30.5%) and information technology (+9.3%) sectors, as well as more than 7% increases each from materials and utilities. We expect both the integrated and wireless segments of the telecom services sector to post strong advances. In information technology, we think the software and services sub-industries will show gains; the hardware side, including communications equipment, peripherals, and semiconductors, should register declines. In materials, only chemicals and forest products are expected to post declines, while the containers, metals, and paper sub-industries should be in the black. Finally, electric and multi-utilities are juicing utilities’ profit growth prospects.

So where’s the problem? Energy. The greatest erosion in first-quarter estimates over the first three months of the year came from that sector, as its 16.5% projected increase was adjusted downward to 3.3%. This was largely because of an expected 18% decline in oil & gas storage & transportation earnings and a 29% drop in oil & gas exploration & production. The integrated oil & gas group, which represents 62% of the sector’s market value, is now expected to register a 4.7% rise in earnings.

S&P equity analysts are projecting a full-year 2007 earnings gain of 6.6%, but this hinges on our forecast of 15% growth in fourth-quarter earnings (see table below). Otherwise, we may be lucky to see a full-year rise beyond 4%, since we are looking for advances of only 3.2%, 5.8%, and 2.7% for the first three quarters.

A little more than three months ago, we were forecasting an 8.2% rise in first-quarter results and a 9.6% gain in full-year earnings. Today, however, owing to elevated oil prices and a slowing economy, our first-quarter estimate for the S&P 500 has tumbled to 3.2%, with eight of the 10 sectors of the S&P 500 posting a reduction in estimates. And our full-year forecast was whittled to a 6.6% increase, with six sectors getting shaved.

However, Wall Street is expecting only a 6% advance in full-year results, according to ThomsonOne Analytics. And since share prices frequently move based on the difference between reality and expectations, share prices may actually benefit if our 6.6% full-year forecast is the more accurate of the two. Investors may be looking beyond this year’s earnings valley to the Street’s expected 11% recovery in 2008 operating results. Either way, S&P’s Investment Policy Committee continues to believe earnings growth will be enough to support our forecast that the S&P 500 will eke out a 6.4% gain to 1510 from the 1418 close from last year.

Separately, S&P’s Investment Policy Committee recently voted to increase the recommended international equity allocation to 25% from 20% and reduce the cash position to 10% from 15%. This reflects this year’s projected 6% decline in the value of the U.S. dollar on a trade-weighted basis, strong international profit growth prospects, attractive valuations overseas, and healthy foreign GDP growth forecasts. Of the 5% we took from cash, we put 4% in international and 1% in emerging markets.

A primary reason for our lower dollar forecast is the continued weakening of the U.S. economy. Economic cycles typically last five years — four up and one down — or, in this case, one soft. We believe the current slowdown looks a lot like the soft landing of 1995-96. A recession can’t be ruled out, however, since there have been eight recessions and only three soft landings in 50 years.

Since inflation remains elevated, we see the Fed starting to cut rates in the fourth rather than the third quarter, likely ending at 4.5% in 2008. This would bring them to a neutral stance, based on projected inflation.

Progression of Earnings Estimates by S&P Equity Analysts






E 1st Quarter
Full Year 2007

% Change
% Chg.
S&P 500 Sector 12/29/06 4/10/07 12/29/06 4/10/07
Consumer Disc. -5.5 -20.6 3.7 -3.4
Consumer Staples 6.8 5.9 8.3 8
Energy 16.5 3.3 6.2 -2.9
Financials 4.8 1.6 6.4 4.5
Health Care 5.9 4.7 15.2 17
Industrials 6.8 4.6 9.1 7.8
Info. Technology 14.5 9.3 21.5 15.9
Materials 11.7 7.4 8.7 2.5
Telecom. Services 31.6 30.5 21.6 26.7
Utilities 10.4 7.9 6.5 8
S&P 500 8.2 3.2 9.6 6.6





E-Estimated. Source: Standard & Poor?s.


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Being honest may not get you a lot of friends, but it'll always get you the right ones. - John Lennon

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