Ireland's stock market was the second-worst-performing equity market in the world last year. Shares lost some 27 per cent of their value and finished 2007 narrowly ahead of Venezuela. Such a huge underperformance reflected a number of specific factors.
First, the Iseq index, which measures the market value of the listed companies, is dominated by financial and construction shares. The major banks and CRH account for some two-thirds of the Iseq's overall value. Last year investors, particularly international investors, became increasingly nervous holders of shares in Irish financial and construction companies. Both sectors were seen as heavily exposed to an overheated domestic property market and therefore vulnerable to a sharp market correction.
In the wake of the US sub-prime crisis as global credit tightened, domestic housing activity declined and property prices fell, Irish share prices plummeted. Foreign investors became net sellers of banking and construction stocks. A rapid sell-off in equities was exacerbated somewhat by the imbalance in size and structure of the Irish stock market. In global terms the Dublin exchange is small, narrowly based and poorly diversified.
Investors in the Irish market were clearly concerned that, given the economy was heavily reliant on construction and property for growth, banks were vulnerable in an economic downturn. A sharp rise in their non-performing loans and bad debts could erode earnings and profitability and weaken their share prices.
Stock markets are often seen as discounting mechanisms for future events, whereby the market anticipates economic recessions and recoveries before they fully materialise, and price shares accordingly. Irish bank shares have fallen more than 40 per cent since peaking last February. Nevertheless, UBS, Europe's largest bank, this week opted to lower its ratings for Irish bank stocks. It claimed that commercial property prices could weaken further, requiring higher provision for loan defaults.
The current market valuation of Irish financial stocks, in what is their second-worst bear market in the past 30 years, now assumes the worst. As Davy stockbrokers noted recently, the only way to explain current bank valuations is "if bad debts explode over the next year or two". But, as yet, neither the evidence from the banks, which are well capitalised and have yet to express concern over their level of bad debt provision, nor reports from the property market suggest that this is likely. If irrational exuberance by investors characterises a market peak, then what now seems like irrational pessimism in the case of Irish bank stocks may mark a market bottom.