Global Insight's Sector Rotation Strategy provides a quantitative basis for sector rotation in a U.S. equity portfolio. Our macroeconomic and industry analyses and forecasts provide fundamental, forward-looking metrics for use in security valuation—such as sector profits, CapEx, and free cash flow (FCF)—to calculate and rank the sectors that have the highest potential for future total return. From this, the "optimal" portfolio is constructed with the sector over- and underweight positions set relative to those in the benchmark MSCI (Morgan Stanley Capital International) USA index in order to maximize the total portfolio return.

Of the 10 sectors that comprise the U.S. stock market, the healthcare, consumer staples, and select components of the financial sector hold the most promise for U.S. stock market investors in 2007. The worst sectors for investing will be energy, consumer discretionary, industrials, and real estate, according to Global Insight's latest stock sector rotation.

Currently, the healthcare sector has the best attributes for an overweight position, from both the fundamental and risk perspectives. Central to both are the robust prospects for strong growth in earnings and free cash flow due to positive demographics, new technology, faster sales, and positive pricing power.

Healthcare FCF turning point indicator is up to a very attractive 1.20, and lowers the PEG ratio down to a level that is less than one-half the value seen on average historically in this sector. Healthcare stock price momentum lag behind the overall market during the past year (shown by a negative reading on the momentum indicator) helping the sector to support a reasonable dividend yield that has been rising in recent years and now stands some 2% above the sector's own historic average.

The consumer staples sector has a sizeable overweight recommendation, helped in part by its "defensive" nature in a slowing economy. This feature is reflected in lower measures of volatility in stock prices and earnings growth rates than is typically seen in other sectors. An attractive sector valuation also boosts the relative prospects for total future return from consumer staples. As in healthcare, stock price momentum lagged behind the overall market during the past year leading to comparatively high level of the sector dividend yield.

Further, while a sector P/E for consumer staples of 19.6 is not particularly low when compared to other sectors, it is lower than its own history (consumer staples have a 10-year average P/E of 23). The forward growth of profits from this sector is strong enough to lower the "PEG" ratio to an even more historically attractive range, and to raise the Free Cash Flow "turning point" indicator well above one. In addition, the improving fundamental indicators are also a large factor in determining an improving credit outlook for this sector.

The outlook for the insurance and, to a bit lesser extent, the banking industries within financials are also positive on balance. These will be supported by continued economic expansion, albeit at a slower pace, a generally good credit quality in their assets, sound capital ratios and reasonably strong financial markets. Nonetheless, there are growing pressures from an inverted yield curve and stiff competition for loans and deposits. Further, the growth rate of demand for new loans is expected to slow in both consumer and commercial credit in 2007.

Perhaps the largest source of slowdown in the financial sector in 2007 will be related to the housing sector. In line with this, the prospects for returns from investing in the real estate sub-sector are very poor, with an under-weight setting indicated by both the fundamental and risk indicators. The fallout from declining real estate markets will also affect areas of the financial sector, such as regional banks and mortgage-related institutions that have large exposure to the real estate markets, real estate brokers, and developers.

The energy and consumer discretionary sectors have unambiguously negative prospects relative to the others in 2007. The energy sector's future prospects are in large part a victim of success of the recent past, having enjoyed by far the biggest run-up in profits and stock market prices over the past few years, largely on the strength of steadily higher oil prices. However, the prospects for a further rise in prices are capped by an expected slowdown in the U.S. economy and price-induced attempts to lower demand.

In addition, dividend payouts from the energy sector have not kept up with the growth in profits in the past few years, which has driven the energy sector's dividend yield down to unattractive levels, and lowered the dividend payout ratio to one-third the amount normally seen on average since the 1990s. Further, many portions of the energy sector are committed to large-scale projects and capital investments in coming years, the spending for which will push down on the growth of their free cash flow.

The outlook for a slowing economy will hurt the consumer discretionary and industrials sectors, which traditionally have been the most economically sensitive sectors in the market. In addition, the consumer discretionary sector has very poor fundamental valuation parameters, such as low dividend yield, high P/E and PEG ratios, and low forecast growth in sector profits and free cash flow.

Portions of the industrials sector will also be vulnerable to slowing domestic growth, such as those exposed to the weak domestic autos industry, and adverse market conditions for the construction sector. The prospects for return in investing in industrials are further clouded by a negative reading in both the credit risk indicator and the technical momentum indicator.

The information technology, materials, telecommunication services, and utilities sectors all have neutral settings for 2007 relative to the benchmark. Telecoms and utilities have negative fundamental results that are offset by very positive readings in the technical momentum and risk direction readings. Stable growth in profits and free cash flow contribute to the improvement in telecommunication services' credit quality. Real revenue growth and profitability are high in comparison to most other sectors, driven by strong wireless growth. Additionally, there is a wave of industry consolidation that is coinciding with improving pricing conditions, aggressive cost cutting, and a positive regulatory environment. The industry's pricing power remains strong, although it has slowed from previous years.

The information technology sector shows mixed signals—it has a 12-month ahead positive view versus a negative 3-month ahead view—which is often a sign of a "bottoming out" price in stock prices. The short-term view still reflects the consequences of the past 23-year Fed tightening policy, which undermined the earnings prospects for growth-oriented sectors such as technology. In 2007 and 2008, the expectation is that the Fed has ended the tightening policy, so a decline in energy prices, continued strong corporate profits in the sector, and brisk business spending on technology supports the positive 12-month view for information technology. So, a negative, short-term view, combined with positive, long-term perspectives, in the context of simply "average" technical momentum and risk direction indicators, result in a neutral setting for technology relative to the benchmark.

Our Sector Rotation Strategy is produced as part of our World Industry Service's Stock Sector Benchmarks, designed to assist asset managers in identifying the most profitable sectors for investment in the U.S. and international stock markets. This service is updated on a quarterly basis for all clients of this service.

A full description of the Sector Rotation Model and factors driving the current recommendations are available to subscribers on the Cost and Industry section of the Global Insight Web site.

Additional information on the World Industry Service, which provides the platform and fundamental forecasts for the Stock Sector Rotation Model, is available at the following links:

• World Industry Service
• WIS Stock Sector Benchmarks
• WIS Sector Risk Ratings

Recommended Portfolio Weighting for 10 U.S. Stock Market Sectors over the Next 12 Months

	Fundamental Indicators1		Technical Indicator2	Risk Direction3	Recommendation
	12-Months Ahead	3-Months Ahead
Health Care	+	+	-	+	Over Weight
Consumer Staples	+	+	-	+	Over Weight
Insurance, Banking & Related Financials	+	+	-	+	Over Weight
Information Technology	+	-	=	=	Equal Weight
Materials	+	-	=	-	Equal Weight
Telecomm. Services	-	-	+	+	Equal Weight
Utilities	-	-	+	+	Equal Weight
Consumer Discretionary	--	--	+	=	Under Weight
Real Estate	-	-	+	-	Under Weight
Energy	-	-	+	-	Under Weight
Industrials	-	-	-	-	Under Weight

[Over (+), equal (=), or under (-) weight setting relative to the portfolio benchmark]

(1) Over/under-weight setting from Global Insight WIS Stock Sector Rotation models

(2) December 2006 Sector Price Index divided by the average from the previous 12 months

(3)Expected level of deterioration or improvement (over 2005-2007) of the Sector Risk Rating, divided by the 2006 level of the risk rating

December 2006

by Mark Killion, CFA, and Natasha Muravytska

www.globalinsight.com

www.wmrc.com