The sharp fall in the Iseq this year is severe, but not unprecedented, and history shows it can rebound, writes Rory Gillen.

The 25 per cent decline in the value of the Irish stock market year-to-date in 2007 is severe, but we've been here before.

A glance at the accompanying graph shows that over the 38-year period from 1970 to 2007 inclusive, there have been five previous occasions when the Irish market recorded such a severe decline.

In four out of those five years, the subsequent year saw a strong rebound. 1974 was the exception, where further steep falls followed the 1973 decline. The surprise in 2007 is that the decline in the Iseq has occurred when the majority of global stock markets have delivered positive returns.

The disconnect, however, is more easily understood when one takes into account the dominance of the financial and building materials stocks in the Irish market. Both these sectors across the global markets have declined materially this year, with the US sub-prime crisis undermining confidence in banking shares and the prospect of weakness in housing and property markets weighting on building materials companies.

Some selling by overseas institutional investors, who feel that the Irish economy is past its best, and the unwinding of leveraged positions held through contracts for difference accounts, have also contributed to the weakness in the Irish market.

Where to from here then? For the vast majority of investors, attempting to time the stock market is a mug's game and this article is not an attempt to call the turn. Rather, at times like this, it may be more helpful to highlight the value now on offer.

Currently, the aggregate market value of the companies listed on the Irish market is €85 billion. Our forecasts in Merrion suggest that, in aggregate, Irish companies will report after-tax earnings, before once-off items, of circa €9 billion in 2007.

An investor then, who buys a broad selection of Irish shares, is getting €9 billion of earnings for an outlay of €85 billion (excluding Elan), which equates to an earnings yield of 10.6 per cent.

The same investment in bank deposits would yield 4 per cent, or deliver a rental yield from Irish residential property of 3 per cent or possibly 4 per cent from Irish commercial property. In this light, the value on offer in Iseq looks compelling.

But we must also take into account the risk that earnings can decline. Let's assume earnings decline by 10 per cent in 2008, an outcome that would assume a recession in the Republic, and possibly elsewhere, and is a scenario considered by most to be highly unlikely, in the Republic at least, but cannot be ruled out.

Such an outcome would reduce the earnings yield to 9.5 per cent for today's buyer. But even a starting earnings yield of 9.5 per cent plus growth in these earnings of 4-5 per cent annually thereafter suggests returns of 13-14 per cent per annum from here over the medium term.

No one ever claimed the markets are rational in the short term - quite simply they are not; fear can take over and over-reactions to the downside are common.

But the stock markets are very rational in the medium term. The true investor, as opposed to the speculator, has the comfort of knowing that where earnings go, share prices eventually follow.

Rory Gillen is a director of Merrion Capital