What is a Bear Market?
A bear market is a period of at least two months of declining stock prices that leads to a falling total stock market value. In this depressed market, the major indexes such as the S&P 500 and the Dow Jones Industrial Average decline by at least 20 percent.
A bear market is a general decline in the stock market over a period of time. It includes a transition from high investor optimism to widespread investor fear and pessimism. One generally accepted measure of a bear market is a price decline of 20% or more over at least a two-month period.
A smaller decline of 10 to 20% is considered a correction.
Bear markets end when stocks recover, attaining new highs. The bear market, then, is measured retrospectively from the recent highs to the lowest closing price, and its recovery period is the lowest closing price to new highs. Another commonly accepted end to a bear market is indices gaining of 20% from their low.
A bear market followed the Wall Street Crash of 1929 and erased 89% (from 386 to 40) of the Dow Jones Industrial Average’s market capitalization by July 1932, marking the start of the Great Depression. After regaining nearly 50% of its losses, a longer bear market from 1937 to 1942 occurred in which the market was again cut in half. Another long-term bear market occurred from about 1973 to 1982, encompassing the 1970s energy crisis and the high unemployment of the early 1980s.
Another bear market was the Stock market downturn of 2002. Yet another bear market occurred between October 2007 and March 2009 as a result of the financial crisis of 2007–2008. The 2015 Chinese stock market crash was also a bear market. In early 2020, as a result of the COVID-19 pandemic, multiple stock market crashes have led to bear markets across the world, many of which are still ongoing.
Understanding Bear Markets
Stock prices generally reflect future expectations of cash flows and profits from companies. As growth prospects wane, and expectations are dashed, prices of stocks can decline. Herd behavior, fear, and a rush to protect downside losses can lead to prolonged periods of depressed asset prices.
The causes of a bear market often vary, but in general, a weak or slowing or sluggish economy will bring with it a bear market. The signs of a weak or slowing economy are typically low employment, low disposable income, weak productivity and a drop in business profits. In addition, any intervention by the government in the economy can also trigger a bear market.
For example, changes in the tax rate or in the federal funds rate can lead to a bear market. Similarly, a drop in investor confidence may also signal the onset of a bear market. When investors believe something is about to happen, they will take action—in this case, selling off shares to avoid losses.
Bear markets can last for multiple years or just several weeks. A secular bear market can last anywhere from 10 to 20 years and is characterized by below average returns on a sustained basis. There may be rallies within secular bear markets where stocks or indexes rally for a period, but the gains are not sustained, and prices revert to lower levels. A cyclical bear market, on the other hand, can last anywhere from a few weeks to several months.
Phases of a Bear Market
Bear markets usually have four different phases.
- The first phase is characterized by high prices and high investor sentiment. Towards the end of this phase, investors begin to drop out of the markets and take in profits.
- In the second phase, stock prices begin to fall sharply, trading activity and corporate profits begin to drop, and economic indicators, that may have once been positive, start to become below average. Some investors begin to panic as sentiment starts to fall. This is referred to as capitulation.
- The third phase shows speculators start to enter the market, consequently raising some prices and trading volume.
- In the fourth and last phase, stock prices continue to drop, but slowly. As low prices and good news starts to attract investors again, bear markets start to lead to bull markets.
Key Traits of a Bear Market
However, bear markets are often triggered by an economic downturn — a contraction phase in the business cycle. Negative news or events can also cause stocks to change course.
The main characteristics of a bear market include:
- Investors turn pessimistic. They decide to sell current investments or stop buying more. This increases the supply of available shares, depressing prices.
- Stock values decline. Listed companies are worth less on paper due to their lower stock prices.
- Investor sentiment turns negative. The consensus is that the market’s stopped growing and won’t appreciate anytime soon. Investors move money to safer and steadier assets, like Treasury bills and investment-grade bonds.
- Companies make less money. Consumers are buying less, investors have lost confidence. Corporate earnings and profits fall or stagnate. This leads to firms laying people off, cutting production, and curbing research and development.
- The economic malaise spreads. Money becomes more tight, leading to the risk of deflation. Markets, production, spending are moribund.
- A turnaround occurs. Conditions bottom out. Lower interest rates stimulate spending and borrowing again. As activity and confidence return, stocks rebound and the market begins a bull run.
How to Invest in a Bear Market
Bear markets can certainly be scary times for investors, and nobody enjoys watching the value of their portfolios go down. On the other hand, these can be opportunities to put money to work for the long run while stocks are trading at a discount.
With that in mind, here are some rules you can use for investing in a bear market the right way:
- Think long-term: One of the worst things you can do in a bear market is make knee-jerk reactions to market movements. The average investor significantly underperforms the overall stock market over the long run, and the primary reason is moving in and out of stock positions too quickly. When stocks plunge and seem as if they’ll keep falling forever, it’s our instinct to sell “before things get any worse.” Then, when bull markets happen and stocks keep reaching new highs, we put our money in for fear of missing out on gains. It’s common knowledge that the main goal of investing is to buy low and sell high, but by reacting emotionally to market swings, you’re literally doing the opposite. Invest in stocks that you want to own for the long run, and don’t sell them simply because their prices went down in a bear market.
- Focus on quality: When bear markets hit, it’s true that companies often go out of business. One of my all-time favorite Warren Buffett quotes is, “When the tide goes out, that’s when we find out who has been swimming naked.” In other words, when the economy goes bad, companies that are overleveraged or don’t have any real competitive advantages tend to get hit the hardest, while high-quality companies tend to outperform. During uncertain times, it’s important to focus on companies with rock-solid balance sheets and clear, durable competitive advantages.
- Don’t try to catch the bottom: Trying to time the market is generally a losing battle. One thing to keep in mind during bear markets is that you aren’t going to invest at the bottom. Buy stocks because you want to own the business for the long term, even if the share price goes down a little more after you buy.
- Build positions over time: This goes hand in hand with the previous tip. Instead of trying to time the bottom and throwing all your money in at once, a better strategy during a bear market is to build your stock positions gradually over time, even if you think prices are as low as they’re going to get. This way, if you’re wrong and the stock continues to fall, you’ll be able to take advantage of the new lower prices instead of sitting on the sidelines.