“History doesn’t repeat itself, but it does rhyme,” goes the old saying. In that regard, the pattern of the sovereign debt crisis in Europe, its effect on the Euro currency, and the impact on the stock market is a familiar tune from the 1997-98 foreign debt and currency crisis that roiled world markets. While every crisis has its unique elements, I think it’s a valuable lesson to revisit how that crisis played out, and how the stock market responded before, during and after the crisis resolved.

The first jolt to world markets began in 1997, when investors began fleeing the currencies of many developed and emerging Asian markets after a real estate bubble burst (sound familiar?). While foreign stocks suffered big losses, U.S. stocks held up well, and in short order calm returned to the capital markets when the International Monetary Fund (IMF) moved in to prop up currencies from Korea to the Philippines.

Heading into the summer of 1998, the U.S. stock market had enjoyed strong gains for the year. But the Asian currency crisis had caused commodity prices to plummet – taking oil to an unthinkable $8 a barrel – and soon commodity-dependent Russia was teetering on the financial brink. Fear again swept world markets as investors obsessed over whether Russia would devalue its currency and default on its debt. Stocks around the world began to move steadily downward.

Those fears were realized in mid-August, when Russia succumbed to market forces and defaulted on its debt. The country’s stocks, bonds and currency collapsed, and panic swept the world stock markets. The S&P 500 index plunged more than 12% the last week of August 1998, including a staggering 7% drop on August 31.

But that wasn’t all. In mid-September, famed hedge fund Long-Term Capital Management was revealed to have had huge positions in the Russian markets that had gone sour. The fund, which had deep ties to all of Wall Street’s large investment banks, announced losses of nearly $4 billion, all incurred in a month’s time. The Federal Reserve was forced to step in and broker a deal with the Wall Street banks to prop up the fund and keep its losses from spiraling through the financial system.

By October 1998, U.S. stocks had seen their gains for the year evaporate into thin air. The S&P 500 index had fallen 14% since the turmoil in Russia began, and the Russell 2000 index of small stocks dropped almost twice that amount, plunging 25%.
Stocks were finished, many pundits said. The market had seen huge gains going back to 1993, and the run was over. It was time, investors were told, to “move to the sidelines” and “get liquid.”

Then, just as dramatically as the downturn began, it ended. With all the bad news already priced in by the market, an unexpected rebound began in November. Over the last two months of the year stocks recovered all of their lost ground and more, gaining about 30% during the last eight weeks of the year:
 
For the round trip – from the beginning of the crisis in Russia through the end of 1998 – the S&P 500 finished up more than 10%. At the end of it all, the S&P 500 finished 1998 with a 20% gain, but many investors experienced losses for the year because they bailed out during the downturn.

Will the current sovereign debt crisis in Europe play out the same way? While the exact path of this crisis will no doubt have its own unique set of circumstances, the parallels are hard to ignore. When countries get themselves into fiscal trouble, the capital markets react. The ironic thing is that it is the very act of reacting by the markets that eventually forces the changes that need to be made. Sovereign governments and the politicians that run them are all too happy to maintain the status quo and allow the hard, politically unpopular decisions to be kicked down the road to another administration. But ultimately investors force action to be taken, lest they refuse to continue to underwrite that country’s fiscal activities in the equity, debt and currency markets.

It’s what happened in the Far East in 1997 and Russia in 1998. And it’s what is happening in the smaller economies of the Eurozone today. Eventually markets will force the fiscal policies that sovereign governments need to adopt in order to allow for future economic growth. For long-term investors, it’s not an enjoyable process to be a part of, but it is a necessary function of the markets that clears the detritus from the financial system and allows for the kind of economic growth necessary for stocks to thrive.

And once the system is cleared, history shows that a powerful market recovery often follows soon thereafter.