The second downturn in share prices

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Cyprus – A future Economic Slowdown

The downturn in Cypriot share prices toward the start of the year was a direct result of the uncertainty caused by the financial sub-prime crisis that hit the banking industry in the US. Since the banking industry is closely associated with investment, the atmosphere of doom there quickly had a severe impact on share prices.
Many European banks quickly discovered they too were vulnerable to mortgage related problems. European shares followed the US downturn. Whatever else one may say about globalization, it is undeniable that today’s financial markets are global. European share prices are closely linked to US share prices. This is evident from even a casual observation of the variations in New York share prices compared to those of London, Paris, Milan and Cyprus.
After a few months, the financial crisis appeared to subside. It appeared the worst was over. With spring came the first signs of a second downturn in share prices, this time related to events in the real economy. Oil prices which had been rising took to the stratosphere. A new phenomenon was the onset of a world shortage in commodities driven by the rapidly developing economies of India and China. Accounting for almost a third of the world’s population, their demand for oil, grains and metals introduced a new level of demand for these commodities that sent their prices upward. Unemployment jumped in the US, consumer confidence dropped, inflation rose.
The central banks of the developed economies were able to bring about some measure of control over the first, the banking crisis. But when the second downturn hitting the real economy arrived, the Federal Reserve was (and is) effectively out of ammunition. Any further lowering of interest rates would only spur the inflation already evident in oil and commodity prices. The prospect of no further interest rate reductions and even interest rate increases has placed further downward pressure on share prices.

Cyprus – A future Economic Slowdown

Share prices in Cyprus have been closely connected to these events, with a major difference. For every drop in the New York Dow Jones index of share prices, Cyprus share prices drop much more. While the Dow Jones has dropped some 14% from the first of the year, the XAK has dropped 40%! This is despite the fact that we have not had a sub-prime crisis here. The banks have been earning record profits, employment is high and Cypriots are confident and spending as if there were no tomorrow. Cypriot banks are enjoying financial results that most foreign banks in Europe and the US can only dream of.
We will no doubt feel the real impact of rising oil prices and commodity prices in the future, particularly this winter. It is also fairly certain that the overblown land prices that currently prevail in Cyprus will also suffer. However, the special circumstances that brought about the sub-prime crisis are not present in Cyprus (thanks partly to the policies of the central bank).
Cyprus is also different in certain other respects. Although share prices here are more volatile than those in the major developed countries, a comparison of countries on the basis of the real economy shows the reverse. After the dot-com bubble of 2000, the US and much of Europe suffered a recession (Gross National Product contracted). The economy in Cyprus, showing less volatility, did not contract. During the post-bubble period, Cypriot GNP growth continued to grow but at a slower pace, dropping to an annual low growth rate of 1.9% for a year and subsequently growing rapidly. Eventually, this continued growth in the economy made itself felt in Cypriot share prices. People who had taken advantage of the exceptionally steep fall in share prices during the last economic slowdown made a killing when the upturn came.
Will this be repeated? No one knows. The XAK is moving downward sharply and is likely to continue in this mode. The Cypriot economy is still growing at a healthy rate but we will not escape untouched. An impact from the global increase in prices and the credit crisis will eventually affect Cyprus. Indeed, the indications are that this is already happening. The good news is that once again the impact on the real economy here is likely to be less than that in the major industrial countries.
In brief, it is likely that once more we will see that share prices are dropping faster than warranted by a decline in the real economy and the earnings of Cypriot companies. This means that the amount of money required to buy future income derived from owning Cypriot shares is falling. This is reflected in higher dividend yields and lower price earnings ratios, particularly in the banking sector. Investors buying shares for future capital gains are taking a beating. However, investors buying shares for future income may still do well.
All this is taking place in a climate of uncertainty which has made investors fearful. Is this an opportunity? Buffett’s advice: “be greedy when others are fearful and fearful when others are greedy”.