Why Severe 19% Correction Could Happen Like 1998

What next for the stock market? After hitting a record high on January 26, the S&P 500 Index (SPX) started sliding, with a big sell-off on Monday, a modest recovery on Tuesday, and a small downtick in Wednesday. Students of market history might look to 1998, Bloomberg suggests, indicating that there are several important parallels between then and now. These are: huge increases of stock prices in the late stages of a bull market; extreme equity valuations by historical standards; tightening of credit by the Federal Reserve; euphoric, even giddy, moods among investors; excessive speculation; low unemployment; rising confidence among businesses and consumers; and negative influences from derivatives trading.

In the summer of 1998, a 45-day correction knocked 19.3% off the value of the index. Bloomberg also sees parallels in the movement of tech stock prices then and now.

The Bull Market Today

The S&P 500 rose by a robust 19.4% in 2017, and has added another 0.3% in 2018 through February 7. After gaining 7.5% through January 26, the index has dropped by 6.7% since then. Compared to the previous bear market low, reached in midday trading on March 6, 2009, the January 26 record close represented a gain of 331%.

The Bull Market Then

Back on July 17, 1998, the S&P closed 430% above its previous bear market low on December 4, 1987, per Yardeni Research Inc. Over the ensuing 45 calendar days, the index shed 19.3% of its value. In that same bull market, there already had been three prior corrections, whose orders of magnitude were 10.2%, 19.9% and 10.8%, respectively. Bloomberg notes that the index had advanced by 31% in 1997, and by another 22% in 1998 until the correction began. Warnings about investor complacency were frequent, Bloomberg adds. 

Still, the 1998 correction soon was forgotten. On July 16, 1999, the S&P 500 was 19.6% above its pre-correction high that was attained almost exactly a year earlier. Another correction, taking the index down by 12.1% would follow. That great bull market eventually would end on March 24, 2000, gaining another 7.7% from July 16, 1999 and 582% from its start in late 1987, per Yardeni.

High Valuations

Prior to the recent selloff, the S&P 500 was trading at a forward P/E ratio of 18.5 times projected EPS, versus a 10-year average of 15.5, Bloomberg says. The situation was even more extreme in 1998, with this valuation metric having reached a value of 25, per Bloomberg.

Howard Ward, chief investment officer of growth equities at Gabelli Funds, tells Bloomberg that "In both instances the market was acting giddy, euphoric," adding "Stocks rising exponentially when there were few factors justifying the advance." The latter comment describes the momentum investing craze that has gripped many investors today. (For more, see also: Why Stock Investors Play the Risky 'Momentum' Game.)

Tech Bubbles

1998 was in the midst of the Dotcom Bubble, from 1995 to 2000, during which time the technology-heavy Nasdaq Composite Index soared by over 400%, followed by the dramatic Dotcom Crash of 2000 – 2002, in which the Nasdaq shed 78% of its value and returned to roughly where it started. The speculative frenzy also included S&P 500 stocks that were expected to ride the technology and internet wave.

In 2017, the S&P 500 Technology Index (S5INFT) led the S&P 500 with a gain of 36.91%, per S&P Dow Jones Indices. Its year-to-date gain in 2018 is 1.55%.

Danger From Derivatives

In 1998, the collapse of hedge fund Long Term Capital Management rattled the markets, and required a $3.5 billion bailout engineered by the Fed. This fund engaged in algorthmic trading strategies devised by some of the, purportedly, best quants on Wall Street, yet still failed. In 2018, the unwinding of so-called "short-vol" trading strategies has contributed to the recent market downdraft. (For more, see also: 6 Forces That May Push the Stock Market Even Lower.)

What's Different Now

There are several factors that should inspire more confidence in stock valuations now than in 1998, Bloomberg adds. Among these are stronger corporate earnings and cash holdings, coupled with stronger, more widespread, global economic growth. By contrast, 1998 was marked by several severe economic problems, including plummeting oil prices, a debt default by Russia, rapidly declining emerging market currencies, and an Asian economic crisis. However, 2018 has its own set of global risks looming over the markets. (For more, see also: 5 Global Risks That Could Hammer Stocks in 2018.)