Worst may be over

Croesus/The Investor's Guide:Like many investors, Croesus has been struggling to come to terms with the magnitude of the shakeout in the Irish equity market this year, and over the past month in particular.

Finding a reliable reference point that can form a sound basis for making investment decisions is extremely difficult in the current turbulent global and domestic financial climate.

The most widely used valuation yardstick, the price / earnings ratio, is singularly unhelpful at the moment because so much uncertainty surrounds earnings forecasts.

In a recession earnings can fall precipitously. If the US were to slip into recession next year, current earnings forecasts for 2008 would prove to be wildly optimistic.

The dividend yield is seen by many investors as a more reliable guide to investment value. Companies are loath to cut their dividend payout and, even in periods of falling profitability, most company boards will seek to continue to increase dividends per share. Therefore, the sharp fall in share prices has led to a big rise in dividend yields.

However, the credit crisis has created a very bearish environment for financial stocks, which traditionally offer above-average dividend yields. In this environment investors are concerned that many banks and insurers may be forced to cut dividend payouts in the coming year in order to boost their capital ratios. Consequently, the dividend yield may not prove to be as reliable a guide to value as in the past.

Given the uncertainties surrounding these fundamental yardsticks of value, Croesus has been analysing past bear markets to place 2008 in a historical context.

The calendar year 2002 was a very bad year for the Irish equity market as the Iseq overall index fell from 5,707 to 3,995 - a decline of 30 per cent. In fact, the index peaked at 6,459 in June 2001 and reached its eventual low point of 3,620 in October 2002. This was a peak-to-trough decline of 44 per cent. In terms of time it took 16 months for this bear market to play out.

How does this compare with the current bear market? The year-to-date return of the Irish market is now about 30 per cent, which is just in line with the 2002 fall. However, the index peaked earlier this year at just under 10,000 and hit a recent low of 6,343 - a decline of 36 per cent. Therefore, the magnitude of the market fall is now similar to the 2001/2002 episode. If the peak-to-trough decline of 44 per cent were to be repeated it would imply a low for the index in this bear market of 5,589. The market has bounced from its recent low and it currently stands at approximately 6,645. Taking an index level of 5,589 as a potential low implies that the potential downside in the market is now 16 per cent.

Of course, there is no reason why the current bear market should behave in the same way as the previous one. However, Croesus concludes that there is a reasonable chance that we have already witnessed a large part of the current bear market in terms of actual price declines.

There is even a chance that the recent low could prove to be close to the eventual low point, suggesting that there is only 5 per cent to 10 per cent downside from current levels.

If the worst-case scenario of a US recession occurs next year, then the impact of this on an already weakening Irish economy and equity market would be severe. However, the more likely scenario is that cuts in official interest rates in 2008 will limit the damage.

The doomsday scenario of widespread credit contraction is a possibility, although the more likely scenario is that central banks and financial institutions will muddle through.

The financial backdrop will remain highly volatile for quite some time. However, for the Irish stock market at least, we may already have suffered the worst of the share price falls.