Equity markets rallied strongly in the last few months of 2002. Even allowing for some renewed declines in December, all the major benchmarks, apart from Japan, recorded significant gains in the final quarter. For the US and the eurobloc area, the rally brought the indices more than 20 per cent above their low points of early October - a technical bull market in both cases.

However, for the year as a whole, all the major benchmarks showed negative returns - for the first time since 1939-1941 during the second World War.

Equity market movements reflect a combination of earnings and valuations adjustments, and both were factors influencing last year's market movements. Earnings disappointment was a particular feature as the year unfolded.

Earnings estimates in the major markets were revised downwards during the year. The average downgrade was almost 10 per cent in the US and Britain but was almost 30 per cent for the larger capitalised stocks in Europe.

The failure of earnings to live up to expectations mainly reflected the failure of the global economy, led by the US, to pull out of the slowdown in the manner many had expected. By the end of 2001 many of the forward-looking indicators in the US economy were pointing to a better year in 2002. Having declined for the first three quarters of 2001, GDP expanded at an annual rate of 2.7 per cent in the fourth quarter and a very impressive 5 per cent rate in the first quarter of 2002.

However, the main drivers behind the recovery were a reduction in the inventory drag and an acceleration in spending on consumer durables, mainly due to discounting in the car market. Neither provides a solid platform for sustainable recovery and many of the indicators turned down again in the summer and autumn months.

Over the past 10 years, the Irish equity market has outperformed the overall European averages. Over that period, the cumulative gain in the Irish market has been about 350 per cent compared with a gain of about 150 per cent for the main European averages.

It maintained that record again in 2002, outperforming the Eurotop 300 by 3 per cent. Were it not for the collapse in Elan shares, the outperformance would have been much greater. At the start of last year Elan was the largest stock quoted on the Irish market. It had a market capitalisation of almost €17.5 billion and accounted for 21.7 per cent of the index. However, last year Elan's shares fell by more than 96 per cent and depressed the overall market index by more than 20 percentage points. Excluding Elan, the market fell by 9 per cent, a significantly better performance than the European average.

A very strong performance by the financial sector was a feature of the Irish equity market in 2002. Having outperformed the European banking sector by 15 per cent in 2001, the sector outstripped its European counterparts by 40 per cent in 2002. Its cumulative outperformance since the relative graph turned in the middle of 2000 is now more than 100 per cent.

A resilient earnings performance was at the heart of the strong showing by Irish banks. Over the past 12 months, 2002 earnings forecasts for the European banking sector have been downgraded by almost 20 per cent on average. The latest 2002 estimates for the Irish banking sector are almost 8 per cent higher than they were this time last year.

The failure of the global economy to recover in 2002 was all the more disappointing given the extent to which policy makers, monetary and fiscal, have tried to offset the downdraft from the corporate sector. That in itself poses a dilemma for 2003. With interest rates and bond yields at 40-year lows and most major economies running large fiscal deficits, there are few policy levers left to pull. At the same time, there are still very large financial imbalances in the world economy - most notably a highly leveraged US consumer sector and its counterpart in the balance of payments deficit of the US economy. Until those financial imbalances are repaired, the global economy is likely to continue to grow at sub-par rates.

That is not an environment conducive to a sustained recovery in equity values, particularly given that valuations, at least in absolute terms, remain high by historic standards. We would not rule out the possibility that equity markets could decline again in 2003.

In this type of environment, the Irish market has continued to perform ahead of most other European centres, particularly if the impact of the collapse in the Elan share price is excluded. This reflects the defensive composition of the Irish market and the corresponding resilience of the earnings performance of its larger components, particularly the banks.

If the global recovery remains as anaemic as we anticipate it will, and equity markets remain under pressure, these characteristics should stand the ISEQ in good stead and allow it to again occupy a position towards the top end of the performance rankings.

Irish financials look to have sufficient momentum to continue to outperform European banks, at least for the first half of the year. Many of the non-financials look to be trading on very competitive multiples on both historic and international comparisons. They also have healthy balance sheets and strong cash flows that will attract increasing attention. As the recent spate of corporate activity has shown, corporates will take advantage of opportunities if the market fails to recognise them.

Robbie Kelleher is head of research at Davy Stockbrokers