Dow Bond Ratio Resembles 1987 and 1998 Equity Market Corrections

Back on February 3 I posted End of Rally or End of Bull: Is It 1987, 1994, 1997, 1998, 2000, 2007 or 2014? it was fortuitous timing since the market plunged on Monday February 5 with the implosion of short volatility products. The post wasn't a very short-term call though, instead it was a long-term look at a severely overbought market relative to bonds or severely oversold bond market, or some combination in between.

Now that stocks have fallen for roughly two months the extreme overbought condition of stocks has evaporated. The two historical periods with similarly extreme overbought conditions are 1987 and 1998. A 1987 analog would result in a rapid stock market decline in a very short period of time. The 1987 analog itself lines up very well with 1929. Whether a crash would more resemble 1929 or 1987 would only be known in the future based on whether the economy rebounded quickly or sank into a deeper depression.

The 1998 analog calls for a swift 20 percent correction led by technology shares, but then a melt-up rally over the next 18 months to the final top. The are some similarities between that late 1990s market and today. Technology has been leading the market by a wide margin, technology flows dominate the market, and there's substantial under performance in consumer staples if not yet a stealth bear market. A major difference may be the Federal Reserve. It slashed rates heading into 1999 for fear of the "Y2K bug" and that money poured into Internet stocks. This time it is tightening and a 20 percent decline in some sectors may not be enough for it to reverse course. A similar melt-up in stocks seems unlikely then, but a less eye-popping final bull high may yet follow (and perhaps a new multi-year high in yields) if this analog holds up.

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