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Scoping Out First-Quarter Earnings

The week of Apr. 10 is when the earnings-reporting season for the first quarter begins in earnest. As seen in the table below, which compares Standard & Poor's equity analysts' estimates on December 31, 2005, with those as of April 4, 2006, S&P believes companies in the S&P 500 will have increased operating results by 11%, driven by above-market gains for the Energy, Health Care, and Industrial sectors.

Below-market gains are expected to come from Financials, Information Technology, Telecom Services, and Utilities, along with year-over-year declines in earnings likely to be recorded by the Consumer Staples and Materials sectors.

FINANCIALS UP. Even though S&P equity analysts are expecting the S&P 500 to have posted its 16th consecutive double-digit increase in year-over-year operating earnings during the first quarter, the gap between success and failure has narrowed since the end of last year, when we forecast a 13% advance in first-quarter results.

The trend in projections for the first quarter is also lower for eight of the 10 sectors in the S&P 500, with the outlook for the Consumer Staples sector slipping into negative territory. Only our estimate for companies in the Financials Sector has improved, albeit modestly.

Full-year 2006 forecasts also have been trending lower over the course of the first quarter for seven sectors. We believe higher interest rates and elevated oil prices, along with a strengthening of the U.S. dollar over the past year and more modest increases in consumer spending, will likely be the stated reasons for the more moderate results.

PRICIER SMALL-CAPS. While S&P equity analysts' full-year forecast for the S&P 500 has held fairly steady (now a 10% gain is estimated, vs. an earlier 11% forecast), the small-cap story is a bit different. At the end of 2005, we expected to see a 19% increase in earnings for the S&P SmallCap 600 index.

Now, however, we look for a 17% advance. What's more, small-cap stocks may be getting pricey, in our opinion, as they sport an average p-e ratio of 18.2 times, vs. 15.4 times for large-caps, based on these reduced 2006 estimated earnings.

Is it time to pull the plug on stocks? Not just yet, in our opinion. S&P's Investment Policy Committee continues to project a 1,360 year-end 2006 price level for the S&P 500. We believe this 9% price appreciation will likely be achieved by healthy economic growth, a mid-year end to the Fed's rate-tightening program, a resulting renewed weakening in the U.S. dollar (which could aid exports), and an eventual moderation of energy prices.

The valuation of the S&P 500 remains attractive, in our view. At 16.3 times trailing 12-month operating earnings, it remains 17% below the average trailing p-e of 19.7 times since 1988, when S&P first began tracking operating results. Even without a p-e expansion between now and the end of the year, $84.34 in projected earnings for the S&P 500 would translate into a yearend price of 1,375. We therefore recommend staying the course with equities.

Progression of Earnings Estimates by S&P Equity Analysts

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