Croesus/The Investor's View: 'Sell in May and go away" is a piece of stock market folklore that would certainly have paid off in the Irish equity market this year. It's possible that the appalling summer weather has something to do with the current market weakness, although this theory doesn't hold up given that British equities have held up quite well in the face of their severe floods.
In fact most international stock markets have performed quite well so far this year as can be seen in the table. The FTSE E300 is up a creditable 6.9 per cent although this index disguises some disparate returns among European markets. European equity markets this year have been led by the continent's largest economy, Germany, where the Dax index is up by 18 per cent. France's Cac-40 index is 6 per cent stronger while the ISEQ Overall index is down 6 per cent so far in 2007.
During the week, global equity markets were spooked by intensified worries regarding the US housing market and nervousness in the credit markets. Countrywide, a leading US mortgage lender issued a profit warning leading to a 10 per cent decline in the stock on the day. Comments from management aggravated worries that the problems in the US sub-prime sector may be spreading more widely.
The broader US equity market fell sharply on the day as financial results from a number of other companies also disappointed. Negative sentiment spread across the Atlantic and European markets were also hit. Financial and construction stocks were hardest hit with the Irish financials yet again underperforming.
The apparent linkage between developments in the US mortgage market, and the US sub-prime mortgage market in particular, and the price performance of Irish shares is more apparent than real. Developments in property markets are primarily a function of local and domestic factors.
On a day-to-day basis investor sentiment is heavily influenced by the US market. However, over time, the factors of most relevance to each market do gain precedence. Indeed, despite all the worries about the US housing market over the year, the broader US equity market has in fact performed quite well. The S&P 500 index is up by 6 per cent year-to-date, the Dow Jones Industrial Average is up by 10 per cent and the Nasdaq has risen by 9 per cent. Even adjusting for the weak dollar would still leave a euro-based investor in US equities well up on the year so far.
Therefore, in looking for explanations as to why the Irish market has performed so poorly this year, the US sub-prime market is not a candidate. One very simple explanation emerges from the 2006 return statistics. The total return from the Irish equity market last year topped 30 per cent - far ahead of the 16 per cent rise in the FTSE E300 and the 13 per cent rise in the FTSE100. The comparison with the paltry rise of 2 per cent for the S&P500 index in 2006 is even starker.
In December alone the Irish market rose by over 8 per cent! With the benefit of hindsight, the Irish market got ahead of itself late last year and needed ongoing injections of fresh good news to keep moving forward.
Although the Irish economy remains in good shape, it has become clear that a fundamental transition towards a slower pace of growth is occurring. The housing market has led the way in this regard and the only issue now is how sharp will the contraction in housing be.
House completions for the first half of the year will be similar to last year's level. However, the data for housing starts point to a sharp slow down in the second half. House completions in 2006 peaked at 88,000 and forecasts for the year now range in the 75,000-80,000 range.
The focus is now shifting to 2008 with one recent forecast of completions of just 65,000. This would represent a hefty fall of 26 per cent from the 2006 peak.
Several studies of the Irish economy and demographics have concluded that the equilibrium rate of housing output for the Irish economy is approximately 60,000 units per annum. It looks to Croesus that the construction industry is rapidly going through the difficult adjustment to this lower level of output. This of course implies a sharp slowdown in the overall pace of economic and employment growth.
It is not surprising that the financial stocks should suffer in this environment. As well as the obvious reduction in mortgage demand, a lower level of housing output means a fall off in the demand for related financial products such as insurance. Furthermore, Irish financial stocks are far less geographically diversified than are Irish industrial stocks. This is reflected in the relative performance of financials so far this year. The ISEQ Financial index is down 8.5 per cent year-to-date compared with the fall of just 1.5 per cent in the ISEQ General index.
At current prices Irish financial stocks now offer very good long-term value but are likely to remain undervalued while the Irish housing market remains at the current crossroads. The news emanating from construction will be poor for some months and, until the likely magnitude of the slowdown becomes clearer, Irish financial stocks will remain under a cloud.
