** IBD and the "Correction of 1998" ** January, 1999.
Loren Fleckenstein By the time the major indexes topped in mid-July, stocks had delivered the longest bull market in U.S. history - a bear-free ascent spanning seven years and nine months.
An army of doomsayers was more than ready for the end. For months, many pundits warned the stock market had entered a speculative fantasy land. It was just a matter of time, they intoned, before the bubble burst, inflicting an overdue comeuppance upon investors.
The summer bear market failed to live up to the gloomy forecasts. The '98 downturn lasted a scant 30 days, making it the shortest bear on record. It also made the speediest recovery - 18 weeks from the July 17 closing peak on the Dow Jones industrials to the first post-bear high on Nov. 23.
Indeed, the hardship was so brief and, by some measures, so shallow, that many market professionals debate whether the decline qualifies more as a correction than a bear market.
''To me, you definitely had a bear market,'' said Edward Nicoski, technical strategist at Piper Jaffray. ''The average stock from peak to trough fell 37%. That's exactly the same loss from peak to trough that we experienced in the bear markets of 1990 and 1987.''
John Bollinger, president of Bollinger Capital Management, stands in the correction camp. He says stocks underwent a decline within a still-intact cyclical bull market. He rests part of his case on technical pioneer Arthur Merrill's definition of a bear market, a decline of 23% on the Dow from closing peak to closing trough.
By comparison, the blue-chip average slid 19.26% from a July 17 closing high to an Aug. 31 closing low. The drop in the S&P 500 Index also fell shy of the mark. The large-cap index lost 19.34% over the same time frame. If one uses intraday peaks and lows, the big-cap damage was -21.0% on the Dow and -22.45% on the S&P.
But more important than scoring conventions, Bollinger argues, is the psychological and economic aftermath of a downturn.
''A bear market is a large-scale phenomenon that occurs relatively infrequently,'' Bollinger said. ''It invokes a profound change in psychology. That change is best described as the turning of investors into non-investors. A correction dampens spirits but does not kill them.
''At the end of a real bear market, you can't sell a stock to anybody. The speculators leave the business. Huge numbers of people are willing to buy at the end of a correction. That would not be the case in a bear market. There is no one left to buy. The few brokers that are left in the typical brokerage office are very lonely people.''
Bollinger, however, concedes stocks exhibited a ''sectoral'' bear market. ''The big-cap indexes miss the carnage inflicted upon the broader market.'' The Value Line Geometric Index, an equal-weighted index of 1,700 stocks, including many small caps as well as the S&P 500, lost 31.81% from peak to trough. The Nasdaq composite fell 29.55% from July 17 closing high to its Oct. 8 closing low.
It's been a lopsided match between small caps and large caps for a long time. For starters, small stocks got relatively meager servings in the '90-'98 feast. While the Dow and S&P 500 quadrupled in value over the course of the great bull market, the small-cap Russell 2000 settled for a 58.38% gain from trough to peak.
To add insult to injury, small caps bore the brunt of the bear. The Russell made its last closing high on April 21 and fell 36.86% from that peak to a closing low on Oct. 8.
Christine Callies, chief investment strategist at CS First Boston, says investors should not try to apply black-and-white definitions to the downturn. In the brevity and shallowness of the drop on the S&P and the Dow, it looks like a correction. ''But anyone who was overweighted in small caps definitely experienced a bear market,'' she said.
What precipitated the decline? The mind demands an answer, but first a word of caution.
In the long run, prices reflect earnings. But as noted by William Miller III, manager of Legg Mason Value Trust Fund, market moves reflect the interactions of millions of daily trading decisions and news inputs. In the short run, prices reflect the shifting mood of the crowd.
No one has a full picture in such an environment. And even hindsight is less than 20-20 when assigning causes. The best market pros live in a world of probabilities, not certainties.
That said, many analysts believe that the late-stage bull market drove equities to record or near-record values in relation to such measures as earnings, cash flows and book values. At that level, the market was vulnerable to earnings disappointments as well as large- scale economic scares. Investors got both.
First Call recorded a surge in negative earnings pre-announcements in June and July, and a corresponding drop in third-quarter expectations as well as downward revisions for the fourth quarter.
Meanwhile, the dollar began sliding against European currencies, eventually falling 13% from 1.83 German marks in July to 1.59 on Oct. 8, corresponding exactly with the bottom on the S&P 500. Peter Canelo, U.S. investment strategist at Morgan Stanley Dean Witter, believes President Clinton's troubles helped erode the dollar, which in turn caused a repatriation of European capital in August.
While valuation measures appear nearly powerless to time market turns, a number of market pros still recognized the onset of the bear early. By and large, they relied on technical analysis - the study of price and volume action of individual stocks and indexes.
Greg Kuhn, hedge fund manager and president of Easton, Pa.-based Kamco Capital Management, was troubled by a variety of signals. The run-up in July was led by fewer and fewer stocks. As the Dow and S&P made new highs, the Advance/Decline line continued to drop.
As the market looked more vulnerable, investor optimism barreled higher. The Investor's Intelligence survey of newsletter advisers polled a week-to-week rise in bulls to 52% from 41%. For Kuhn, the final sign came from his own trading.
''I had six or seven stocks breaking higher from what looked like sound base formations,'' Kuhn said. ''They'd break out for one day, then they'd sell off for two days, right into the pivot area. It's fine when one or two do that. But when you have four or five stocks in a row, that's not normal. That's when the hair really stood up on the back of my neck.''
In a July 21 memo to clients, Kuhn warned, ''The intermediate term advance that began off mid-June lows is very close to ending if it's not over already.'' He characterized the June- July run-up as ''nothing more than a larger topping process. In fact, not a single breadth indicator I track managed to confirm the market's all-time highs.''
On July 27, Kuhn wrote to his clients: ''The conditions are now more ripe than at any time since 1990 for a serious decline.''
The crescendo came in the world market sell-off in August following the Russian financial meltdown. The bottom seemed to occur Aug. 31. The major averages rebounded on Sept. 1 and made a volatile kind of progress over the next four weeks. Then came the frenzy over the Fed.
Investors faced a litany of fears, including possible recession in the U.S., shrinking profit growth, hedge fund failures, financial chaos in Russia, brewing troubles in Brazil, a moribund Japan and global deflation. Many looked to the Fed for a half-point cut in the federal funds rate.
On Sept. 29, the Federal Open Market Committee announced a quarter-point cut in the fed funds rate. The S&P 500, which had been trending upward, dived 6% in two days. The Fed seemed to get the message. On Oct. 15, the central bank announced a second quarter-point cut in the funds rate. The Fed also cut the discount rate by a quarter-point. The S&P, which had bottomed a few days before, rallied 4% on the news, putting the market on its most recent run to new highs.
So what is the legacy of the '98 downturn?
James Moltz, chief investment officer at Deutsche Bank Securities, sees the downturn as a healthy process for the market and the recovery as a positive verdict on world leaders' response to the global financial crisis.
''It's been too easy for too long to do very well in the market,'' Moltz said. ''It was pretty much a one-way street for a long time. That isn't the real world. People needed to be reminded that the market giveth and the market taketh away.''
While the market may have put in a bottom, Nicoski and Callies still await evidence that a new bull market is unfolding.
''I believe we remain in a secular bull market that began in '74. But I don't see convincing evidence we've begun a new bull market,'' Nicoski said. ''Only 6% or 7% of our (industry) groups have made new highs. And the average stock is still down 22% from its peak.''
Callies notes the lack of change in leadership.
''The characteristics of market leadership have really not changed much. In a new bull market, there has been some observable transformation of market leadership,'' Callies said. ''For most of the last eight years, . . . this market has been led by classic growth stocks. The same is true of this rally from the October lows. The leaders are classic growth stocks or growth cyclicals like technology.'' |
