CROESUS:The final quarter of each year is a period when the economic forecasting fraternity sharpen their pencils and focus their attention on the upcoming year and beyond.

In Ireland this is partly a function of the annual budgetary process when official forecasts of the economy are published.

The emerging consensus is for Irish economic growth to slow to a rate of 3 per cent next year and to remain at that rate for the ensuing one/two years.

Earlier this week the ratings agency, Standard & Poor's, issued a set of forecasts that highlighted the risks posed to economic growth by vulnerable construction and property sectors in a number of European countries.

Spain and Ireland were singled out as being especially vulnerable to deteriorating property and construction markets.

While S&P's central forecast for the Irish economy is in line with the consensus, they did point out the risk of a much sharper deterioration in the property market is quite high. Under their "stress scenario", which assumes a sharper than expected construction slowdown, S&P's forecasters estimated that Irish economic growth could drop to just 1 per cent next year.

The international media and investors focused on this latter forecast which added further fuel to the fragile sentiment that continues to pervade the Irish equity market.

Irish financial stocks endured another bad day with share prices falling back close to their September lows.

Like many others, Croesus is a little unnerved by the persistence of the weak trading patterns of Irish financial and construction stocks.

A classic sign of a bear market is that every piece of fresh bad news has an immediate negative impact, whereas good news tends to get ignored.

This has characterised trading in the Irish market over the past six months. Irish financial stocks are now discounting quite a severe slowdown in 2008 driven by a major contraction in activity in the residential construction sector.

In public, auctioneers and developers are putting a brave face on market conditions.

However, the on-the-ground anecdotal evidence from the sector's participants is one of widespread foreboding that things are going to get worse before they get better. Croesus takes the view that the economists' forecasting models do not yet reflect the true state of the market and as a result their forecasts of construction activity are still too high.

There is a real risk that the emerging imbalance of supply versus demand is far higher than the consensus.

An examination of housing output statistics for the past 10 years is instructive in this regard.

In 2006 a total of 88,000 residential units were built in Ireland. In 2003, about 67,000 units were built while in the late 1990s completions were running at about 45,000 per annum.

In the 1991-1996 period completions were running at a rate as low as 25,000 units per annum.

Several analysts have estimated that the annual demand for new housing in Ireland is currently running at approximately 60,000 units. The evidence is mounting that the rate of output over the past 12-18 months was well above demand.

What the magnitude of this excess supply is cannot be accurately determined. Furthermore, a slowing economy would lead to some temporary reduction in demand, exacerbating the excess supply imbalance.

In Croesus' view all of the risks to the current consensus forecasts regarding the Irish economy remain firmly on the downside. For investors the challenge continues to be judging whether the Irish equity market already discounts the pessimistic scenario.

While the year-to-date absolute decline of 18 per cent is very poor, it looks even worse compared with positive returns from European markets as exemplified by the 4 per cent gain in the FTSE E300 and the 3 per cent gain in the FTSE100.

Company financial reports from Irish companies covering the first half of 2007 were generally very good and confirmed that Irish companies continue to provide healthy profits growth.

With profits holding up and share prices falling the Irish market has now derated sharply this year.

On the basis of forecasts of continued profit growth into 2008 the prospective price earnings ratio (P/E) has fallen to just over 9, which compares with a P/E of 12.5 for the FTSE E300.

Given the high weighting of Irish financials in the Iseq, it normally trades at a discount to the European index.

However, the magnitude of the current discount is well above the norm.

This discount can only be justified if Irish corporate profits fall well below current expectations in 2008.

Croesus is more pessimistic than the consensus on the Irish economy and hence expects brokers to gradually revise down profit forecasts for next year.

However, with a large proportion of profits generated by their overseas activities, Irish company profits can continue to grow next year and hence the prospective P/E discount to Europe looks too high.

On valuation grounds the market is cheap but in the short term it is difficult to see where the catalyst of good news will come from.