Past three months are likely to enter the record books as among the most severe for investors, writes Eugene Kiernan

The third quarter of the year provided absolutely no respite to investors who have been whacked by awful stock markets for more than two years. In fact, the past three months are likely to enter the record books as among the most severe experienced by investors.

The German stock market had its biggest quarterly loss for 43 years. The German DAX index was down 37 per cent since the end of June. The US market, which actually did better than its European counterparts, endured one of its five worst quarters in the past 50 years.

In Europe, stock markets slumped in the face of weaker economic data, uninspiring political developments and the prospect of shares being dumped by some of the larger insurance companies. Several European financials are now faced with the prospect of having to raise fresh capital in this harsh environment.

Summer is traditionally a poor time for markets and in this particular year there were sufficient negative cross currents to provoke the sell-off we saw notably in Europe.

In the US, while the August sign-off on accounts may have eased some investor anxiety on the integrity of company statements, Tyco's ability to remain in the headlines continues to weigh on investor sentiment. Other issues have also come more to the fore such as the potential claims from asbestos which have depressed the share prices of such stocks as Honeywell, Haliburton and now CRH.

We also saw reduced optimism from analysts about company earnings over the summer. While company profits will be up in the US in the current year, we did see some downgrades to estimates notably in July and August. It is interesting that this coincides with more stringent analysis standards being imposed by many US brokers.

It is also the case that some of these downgrades are based on a view of a slowing economy through the balance of this year. Main Street continues to see record house sales and reasonable retail sales but Wall Street has zoned in on some of the weaker trends in expectational data such as Consumer confidence and Purchasing Managers surveys.

Why has Europe been so much worse than the US in the past three months? Firstly it doesn't have the momentum of the economic recovery, albeit gentle, that the US is seeing. Growth in the euro zone this year will be sub 1 per cent. As in the US, this will mean some downgrades of company profit forecasts. Weak industrial production data, high unemployment rates, depressed business confidence surveys over the summer all highlighted the fragility of the recovery in Europe.

However the key drivers of European stockmarkets weakness lie in what the actual make up of those markets is. This has been a particularly poor quarter for financials, principally insurance companies - and this is a big sector in Europe. At the mid-year point, for example, the financial sector made up about 27 per cent of the German Dax index; the corresponding figure for the US is just over the 20 per cent mark.

Many European insurers including those in the UK, have significant stockmarket exposure through their portfolio holdings. As markets have fallen back relentlessly over the past two and a half years this has put some companies under solvency pressure.

Of course it's not just insurance which has borne the brunt of the market downturn. Front-line sectors such as media and IT have also been poor. Investors have instead sought out the relative safety of more traditional sectors with more assured cash flow characteristics and better dividend prospects.

This trend emerges very clearly in looking at the sector performance in the UK for the last nine months (see table), where the more traditional, defensive sectors have enjoyed the best performance.

This pattern is familiar enough to Irish investors where the first 9 months of the year have seen strong out performance (and very positive returns) from relatively defensive stocks such as Glanbia, Arnotts and Anglo Irish Bank, while IT companies such as Iona and Riverdeep join Elan in picking up the rear, losing an average of 75 per cent of their value.

Where do we go from here? This has been a prolonged and severe fall in share prices, with the last three months being especially brutal. Investor confidence is at all time lows. By many measures, global stock markets are in reasonable valuation territory.

However we will need to see some resolution of the situation in Iraq before markets make any sustained progress. As for the issues bedeviling many of the large European financials, even a gentle rise in the markets would alleviate much of the pressure.

Eugene Kiernan is head of asset allocation, Irish Life Investment Managers