IN January, Dresdner Kleinwort, the investment bank, published a report called Spain: when will it end? Last week they may have got their answer.

On Tuesday Spain’s leading stock-market index, the Ibex 35, was down 3.5% at one point, and ended the day 2.7% lower as investors panicked about the state of the property market and the real-estate sector plunged.

The five biggest property stocks ended the day down 20% or more. My guess is that, given how horrible the fundamentals of the Spanish property market are, they’ll end the year down rather more.

The problem is twofold: afford-ability and supply. Having risen 270% in the past 10 years, houses in Spain are expensive on any measure. Average prices are about the same as in Britain despite the fact that average wages are lower. Even if they weren’t, one would still expect values to fall.

Most markets move in cycles. As prices rise, more units of any given product – be it houses or hairbrushes – are produced until suddenly there is oversupply and prices start to fall. This is exactly what has happened in the Spanish housing market.

Ten years ago there was a supply shortage, and thanks to low interest rates, easy access to loans and high levels of immigration demand was picking up fast. The result was rising prices and – for some – huge profits.

Today things are different. Not only are interest rates no longer so low – they have risen seven times in the past two years – but there is no shortage of supply.

Far from it. The past decade has seen an extraordinary building binge with new developments sprouting up round the major cities and up and down the coast.

About 800,000 houses were built in Spain last year, five times as many as in Britain. Permission has been granted for another 800,000 this year.

Prices are already falling in many of the areas where foreigners most like to buy.

The Costa del Sol is probably the dodgiest place to be at the moment. Developers are offering huge discounts to get new-build properties away and most forecasts have prices falling by at least another 10% or so this year.

I’d say that is optimistic given supply is not only high but getting higher and the stalwarts of the Spanish coastal market, the British, are fast abandoning what they see as an expensive and corrupt market. They are making their way farther afield to eastern Europe and Latin America.

Two years ago it took three months to sell the average home in Spain. Today it takes twice that.

None of this is to suggest that homeowners in Spain should automatically panic. If you like your holiday home and want to keep it, its market value shouldn’t really matter because it is a question of utility not money.

If you bought ten or even five years ago you are sitting on a huge capital gain so can easily afford to take a bit of a hit on your property’s peak valuation if you want to sell.

The only people who really need to worry are those who have bought as an investment in the past couple of years and those thinking about buying now. The latter might want to think about renting a villa over the summer instead.

However, look beyond the residential property and there is another group who really should consider panicking: Spain’s stock-market investors.

Clearly the construction sector is in trouble. It is heavily indebted and the assets supporting that debt look set to lose value fast. The banking sector also faces difficulties; it has lent heavily to the sub-prime sector in the retail market and to construction firms and developers.

Spanish personal debt has risen by 250% in the past decade and, as interest rates rise, it is inevitable that defaults will too. More than 90% of Spain’s mortgages are on variable rates.

Even outside these two obvious sectors there is reason to worry. In the corporate sector as a whole borrowing is growing at a record rate – an annualised 30% – and debt now stands at 100% of GDP, the highest level in the EU, according to Dresdner Kleinwort. In Britain, by comparison, it is more like 85%.

The upshot is that Spain’s economic growth, which on the face of it is pretty healthy, is dependent almost entirely on the rising debt levels of the corporate and household sectors. That’s not good when interest rates are rising and asset prices falling.

Profit margins are already beginning to contract. Worse from the point of view of investors, Spanish shares aren’t cheap. Several analysts suggest they need to fall 20% just to get back to any kind of “fair value”.

Several days before Spain’s troubles hit the headlines I hada conversation with Simon Pick-ard, manager of the Argos Greater Europe fund. We discussed all these things.

“The writing has been on the wall for a long time,” he said, “you’d need your head examined to put any money in the Spanish market at the moment.”

That’s just as true this week as it was last week. The Ibex is still up 7% this year so it has plenty of room to fall.

Merryn Somerset Webb is a former stockbroker and now editor of Money Week. Her views are personal and investors should always seek professional advice.

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