Although we believe the health-care sector has attractive short-term prospects, that’s not necessarily true for all segments of the sector.

Overall, the outlook for the health-care sector looks strong to us. The U.S. spends nearly 16% of its gross domestic product on health care. And projections by Robert W. Fogel, a Nobel laureate at the University of Chicago Graduate School of Business, are that by 2030 health care will account for about 25% of GDP. That growth will be propelled by an aging population, increases in personal income, and the development of new drugs, medical devices, and technologies. That growth is also translating into employment growth, as health care accounted for 45% of all new jobs in the private sector last year, according to the American Hospital Association.

What’s more, with the economy mired in a harsh recession, the health-care sector has proven quite resistant. In the second quarter, for instance, the S&P 500 Index companies suffered a 39% decline in earnings per share. In contrast, the companies in the S&P 500 Health Care Sector Index reported an increase in earnings per share of 6%. Such positive earnings growth is no small feat in this economy.

But even so, there are certain segments of the health-care sector that have been negatively affected by the recession, and we think that health care may prove less defensive than in the past. In our estimation, three types of health-care companies are especially vulnerable in the near term: hospital companies, drug companies, and high-end suppliers of dental and aesthetic-medicine products (such as dental implants and laser procedures designed to improve appearance).

Three economic catalysts are eroding the defensive characteristics of hospital companies, drug companies, and suppliers of dental and aesthetic-medicine products:

One, some consumers, reeling from a souring economy, are saving more and deferring discretionary spending on health care. And other consumers are losing their jobs and health insurance or are increasingly hard-pressed to absorb the rising costs of insurance copayments and premiums. Consider the following:

*  The personal savings rate, which fell below zero in 2006, is rising rapidly and, in Merrill Lynch’s estimation, will hit 5% in 2010. We think this increased savings will result in consumers spending less on health care.

*  The American Hospital Association calculates that every 1% increase in unemployment translates into a loss of health-insurance coverage for 2.5 million employees and dependents. The nation’s unemployment rate is now at 6.7% and is widely expected to peak at 8.5-10% in 2009. If that happens, a minimum of an additional 5 million people may be without health-insurance coverage then.

*  A study by the Kaiser Family Foundation shows that health-insurance premiums for consumers grew at a 10% compound annual rate from 2000 to 2007, far exceeding any increases in personal income. As a result many consumers have responded by cutting back on health-care spending. Morgan Stanley has found that even small increases in insurance copayments have produced disproportionate reductions in consumer purchases of health-care products and services. In one study, an increase in the average health-insurance copayment of just $7.99 or less prompted 49% of patients to stop taking their medications for high blood pressure over the course of a year.

Two, companies, with their profits under pressure in the recession, are passing on more of their health-care costs to employees, reducing health-insurance coverage, or even discontinuing coverage altogether. A recent Kaiser Commission on Medicaid and the Uninsured study noted that the percentage of employees covered by employer-sponsored insurance has fallen steadily in this decade, from 80.4% in 2000 to 75.7% in 2007. The decreases were steepest for low-income employees, with coverage dropping from 53% to 41%.

Three, reduced tax revenue may compel federal and state governments to cut their reimbursements for health care and tighten the eligibility requirements of patients for Medicare and Medicaid. Health care has become a particularly pressing financial obligation for state governments, consuming 44% of state tax revenue collected. And unlike the federal government, the states can’t make up for any revenue shortfall by paying for health care through deficit spending; they are legally obligated to balance their budgets. According to the Center on Budget Policy and Priorities, the budgets of 43 states are in danger of becoming unbalanced either this year or next year, which has unfavorable financial implications for health care.

As we see it, these three economic strains on consumers, employers, and federal and state governments are likely to weigh heavily on health-care spending over the next six to 12 months, to the particular financial detriment of hospital companies, drug companies, and makers of dental and aesthetic-medicine products.

We expect hospital companies to be hurt by fewer admissions and a surge in bad debts, thereby shrinking their profit margins. Hospitals’ profitability has been hurt in past recessions, such as the recession of 1981-1982, when unemployment was relatively high, as it is now.

In fact, signs of financial stress are already evident at hospitals. In a November 2008 survey by the American Hospital Association, more than 30% of hospitals reported a decline in total admissions and elective procedures. More than 50% of hospitals were subject to a moderate to significant increase in the number of patients unable to pay for care, with uncompensated care for the third quarter rising 8% versus the same period a year ago. And hospitals’ operating margins fell to 2.9% from 3.9% a year earlier.

Among the hospital companies that we think may be adversely affected by these financial stresses are Community Health Systems, Health Management Associates, LifePoint Hospitals, Tenet Healthcare, and Universal Health Services.

For drug companies, the biggest threat to their short-term fundamentals is a lackluster demand for pharmaceuticals. Drug sales in the U.S., the world’s biggest market, are growing far less than expected this year, at only 1-2%, versus an original projection of 4-5%, according to IMS Health, a consulting firm. IMS Health forecasts that drug sales may increase just 1-2% next year as well. Even generic drug sales are slowing, as intense competition in the U.S. and Europe is driving down prices. IMS Health predicts that the global market for generic drugs will expand by 5-7% next year, down from double-digit growth early in the decade. The drug companies themselves are saying that the recession seems to deterring consumers in the U.S. and Europe from visiting their doctors and filling prescriptions.

All of this is likely to impair the near-term earnings of drug companies like Bristol-Myers Squibb, Forest Laboratories, and GlaxoSmithKline.

The near-term earnings outlook is perhaps most impaired for the companies that market dental and aesthetic-medicine products. When consumers reduce their discretionary spending, dental and aesthetic-medicine firms are typically the first to feel the pinch. That’s because many dental and aesthetic-medicine products either aren’t covered or are only minimally covered by the government or private insurers; they are primarily paid for by consumers out of pocket, so they are highly sensitive to the economic cycle. Just as a new cost-consciousness among consumers is fostering the first recession in nearly 20 years in branded luxury goods such as those of Prada, Tiffany, and Montblanc, consumers who previously didn’t think twice about paying premium prices to have their facial wrinkles diminished or their teeth whitened are now thinking twice -- and in many cases are choosing to postpone purchases.

Until consumer confidence is restored, the economy stabilizes, and the employment numbers improve, sales of dental and aesthetic-medicine products are likely to be under pressure, in our estimation. As a result we think the earnings prospects in the short term may be weak for these companies doing business in the dental and aesthetic-medicine markets: Align Technology, which makes teeth-straightening systems; Cutera and Palomar Medical Technologies, which make laser and other light-based products that remove body hair, treat leg and facial veins, and rejuvenate skin; LCA-Vision, which corrects vision with its laser services; Nobel Biocare and Straumann, which make crowns, bridges, and implants for reconstructing teeth; and Thermage, which produces non-invasive skin-care devices using radio-frequency technology.