Ah, but what makes the sprites and lake fairies kick butt is the +3 morale that they get with anga's ruby. You have reduced their morale back down to mediocre. The other thing that makes them own is using +damage items, namely the poison dagger and isshara's whip. The latter is a quest reward for a quest in demonis, which you will get eventually. It gives +2 att and +1 fire damage. Since sprities + lake fairies are in such large number due to low leadership cost, this +1damage has a huge effect.
Some suggestions for you:
1) since you are paladin, you should have little problem getting tolerance level 2, which will negate the morale penalty from the demons. The other option is replacing your demonis troops with elven ones. The eleven archers are quite powerful, and I am frankly astonished that you don't have any sprites.
2) Lake fairies pale in comparison to sprites, which are only slightly slower and in slightly smaller numbers, but do more than 50% more damage per troop, so I would add sprites to your lineup either instead of lake fairies or in addition, see 1), above. Another thing to note is that dryads suck at dealing damage and should mostly be used as support troops ie. using lullaby to put enemy troops to sleep and summoning expendable stacks of thorns to distract enemies and do some damage.
3) Red and Blacks Dragons are ALWAYS available in the land of the dead, amongst the cliffs in Death valley, so extend your explorations there. Of the two, blacks are more devastating with better special abilities but are harder to keep alive without losses while reds are only slightly weaker and have a better special attack and can be kept alive easier.
4) Inquisitors are a good addition to any army despite their rather lacking damage. They are primarily support units with the ability to ressurect any level of unit even level 5 as well as having an ability that blesses a troop (and sprites and lake fairies become far more powerful when blessed) and gives you some rage (only 5-10, but it still helps).
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