Could Have Been a Lot Worse

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 (DELL), Alcatel-Lucent (ALU), and Devon Energy (DVN) — 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 table below, 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.

Progression of Earnings Estimates by S&P Equity Analysts
  Est. 4th Quarter % Change   Est. Full Year 2007 % Chg.
S&P 500 Sector 12/29/06 2/12/07 12/29/06 2/12/07
Consumer Disc. -4.4 0.7 3.7 0.3
Consumer Staples 3.9 6.6 8.3 8.1
Energy -2.7 -7.1 6.2 -1.6
Financials 24.5 27.4 6.4 5.8
Health Care 5.1 1.8 15.2 15.6
Industrials 11.7 15.6 9.1 8.0
Info. Technology -0.7 -1.7 21.5 19.2
Materials 36.7 47.2 8.7 6.2
Telecom. Services 63.6 65.0 21.6 22.3
Utilities -3.6 3.3 6.5 7.3
S&P 500 9.1 10.2 9.6 7.6
S&P 400 11.5 11.5 16.6 15.0
S&P 600 3.1 -0.7 11.9 9.6

In financials, the three sub-industries with the greatest upside surprises included the asset managers and 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 and 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 and 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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