A bear market is usually recognized as a prolonged, serious decline in stock prices. The Securities and Exchange Commission (SEC) defines a bear market as a broad market index decline of 20% or more from a recent high over at least a two-month period. However, other people and institutions might use a slightly different definition.
Normally, it is associated with declines in stock indexes, such as the Standard & Poor 500 Index (S&P 500), the Dow Jones Industrial Average (DJIA), or the NASDAQ Composite index.
Bear markets can also occur in individual securities or different asset classes if they experience a decline of 20% or more over a period of 2 months or more. For example, in bonds, a bearish market can occur in US Treasuries, municipal bonds, or corporate bonds. In addition, asset markets such as the gold, oil, and currency markets can also enter bear territory.
A bear market often accompanies a weak or slowing economy that can turn into a recession. Signs of a weakening economy are rising unemployment numbers, a declining Gross Domestic Product (GDP), and declining business activity.
Although the terms bear market and recession are used interchangeably, it is important to differentiate them. An economic recession describes a slowdown in economic output over two consecutive periods and reflects economic well-being. Recessions, by definition, are economy-wide. On the other hand, Bear markets describe a decline in investor sentiment and can impact specific stocks, asset groups, market indexes, and the economy as a whole.
Understanding Bear Markets and What Causes Them
Various reasons can cause bear markets. A weak, sluggish economy can bring about a bear market. Economic indicators such as lower wages and higher unemployment rates hurt consumer sentiment. Investors can look at them as indicators that a bear market may be on its way.
No one can predict exactly when a bear market will begin. However, it can sometimes be recognized if it is obvious where the economy is in the business cycle. For example, if the economy just started to expand, a bear market is unlikely. However, if the economy is experiencing an economic bubble, or if investors are behaving irrationally and are buying assets at prices that strongly exceed the asset’s intrinsic value, a smart investor will start expecting that a bearish market might be inevitable.
This loss of investor, business, and consumer confidence can cause a bear market. As confidence declines, so does demand, and prices fall. This is the tipping point in the business cycle, and the market decline begins. A stock market crash, which is a rapid, often unexpected drop in stock prices, can trigger this loss of confidence and signal the beginning of a bear market.
The psychology behind bear markets can be described as “the fear of staying in.” Most investors realize that they are temporary events. Different investors have different risk tolerance levels. When financial markets such as the New York Stock Exchange start to decline, many investors flee to the safety of less risky assets to protect their portfolios. Once the sell-off starts, it is hard to stop. As momentum builds, more and more investors will start selling some of their assets, causing prices to drop even further. Please note that certain sectors and stocks (e.g., defensive stocks) can post positive gains even during a bear market.
Government intervention in the economy, such as changes in tax rates or interest rates, often signal trouble, and a financial crisis might be looming. For example, when the Federal Reserve starts lowering interest rates in response to a slowing economy, it can be a sign that a bear market is on its way.
Certain geopolitical issues and trade wars can also be causes for bearish markets.
A bear market can last anywhere from several weeks to many years. Regular bear markets are called cyclical bear markets and usually last anywhere from several weeks to months.
A secular bear market can last anywhere between 10 to 20 years and is driven by long-term trends instead of short-term sentiment. Below-average returns on a sustained basis characterize these markets. Bear rallies can occur within a secular bear market. However, gains are not sustainable, and prices will drop again.
Bull Market vs. Bear Market
A bull market is the exact opposite of a bear market. Stock prices are rising during a bull market, while stock prices are dropping during a bear market. In addition, there is strong investor confidence and optimism during a bull market, whereas during a bearish market, consumer and investor confidence is at an all-time low.
“Bulls” are investors who buy assets because they believe the market will go up. “Bears” sell because they believe there will be a market downturn. Bulls and bears are two opposing forces that are always at play in any asset class. An extended bull market can lead to a bearish market, and an extended bear market can lead to a bullish market.
The bear market obtained its name from how the bear attacks its prey by swiping its paw downward, with the downward paw representing the falling stock price. The bull market got its name from the way a bull attacks by thrusting upwards with its horns, with the upward movement representing the increasing stock prices.
Bear markets and bull markets are normal. For example, since 1928, there have been many bear markets in the S&P 500 Index. However, there have also been many bull markets, and stock prices have risen over the long term.
Phases Of a Bear Market
Bear markets usually have 4 recognizable phases:
Phase 1: Recognition – High prices and positive investor sentiment normally characterize this phase. Almost everybody ignores a bear market’s initial slide as people often see the decline as an ordinary event as prices fall and rise every day. However, at the end of the recognition phase, some investors will realize that a bear market is nearby, and they will start selling their assets to make the highest profits possible.
Phase 2: Panic – In the second phase, stock prices tend to fall sharply. Simultaneously, trading activity and corporate profits will begin to drop. In addition, economic indicators will start deteriorating more than usual, and many investors have lost faith in the market. They sell first and ask questions later. They do so to save themselves from further losses as they anticipate the prices to drop further. This is called capitulation, and this typically happens during high-volume trading and extended price declines of securities. A bear market often leads investors to capitulate or panic sell.
Phase 3: Stabilization – In phase 3, stocks halt their decline, and panic disappears. Investors now realize that there was a reason for the market decline and that, until the problem has been solved, the market will not recover easily.
This phase is a turbulent phase with a lot of volatility. Stocks rally and then crash again, and investor sentiment on Wall Street goes from guarded optimism to despair again. Finally, there is some hope that the end is in sight. During the end of this phase, some speculators slowly start trickling into the market again, and the market starts stabilizing a little. Typically, this is the bear market’s longest period, extending for several months.
Phase 4: Anticipation – Stock prices continue to drop, but more slowly now. Some investors try to benefit from the market by buying stocks at lower prices as they reinvest in the market. And, as more and more investors follow the same behavior, it increases market confidence. The increase in demand leads to rising stock prices, eventually leading to a new bull market.
Bear Market Versus Market Corrections
During both a bear market and a market correction, the stock prices drop. However, there is a difference. The general definition of a market correction is a market decline of more than 10% but less than 20%. On the other hand, a bear market is usually defined as a decline of 20% or more.
Another difference is that a market correction is short-term and lasts less than 2 months, whereas a bearish market may last anywhere from 2 months to several years.
But perhaps the most critical difference between a market correction and a bear market is that a correction occurs when the primary trend of the market is bullish (the market is going up). In contrast, bear markets develop when the primary market trend is bearish (the market is in a downward trend).
A correction represents a short-term decline in stock prices because they have climbed too high and too fast. Market corrections might be a good time for value investors to enter the stock market. However, a bear market very seldomly is a good time to enter the market as it is very unpredictable, and nobody really knows when the market hits rock bottom.
What Is a Bear Market Rally?
A bear market rally is a period during a bear market when asset prices quickly go up in a short period of time before heading back down to new lows. They are not a sign that the bearish market is over.
Bear market rallies can be risky for investors who buy stocks, thinking that things will improve and that a new bull market is nearby. Those long-term investors may end up losing money when the rallies end and the market continues its downward trend. Short-term traders may be able to make some money selling stocks as they increase in value and repurchasing them at lower prices as they continue their downward spiral. Speculating on bear market rallies is a high-risk investment strategy and should only be done by experienced traders.
Investment Strategies In a Bear Market
There are several strategies that investors can follow when investing in a bear market. Certain types of stocks, bonds, and mutual funds perform better when the market is in decline. The best thing to do is to have an investment plan before the bearish market begins.
Above all, DO NOT PANIC.
When the market starts its downturn, Wall Street goes crazy, and many people make the mistake of selling their stocks without having a plan as to what to do with their money and the tax implications. Unfortunately, this can leave investors with large losses and prevent them from benefiting when the market starts to go up again.
Possible investment strategies during a bear market:
Selling out: This is one of the most extreme strategies. This strategy entails selling all stocks and keeping the cash or invest the proceeds into more stable financial instruments such as short-term government bonds. The problem with this strategy is that investors cannot predict when the bear market starts and ends. As a result, investors might miss out on the rebound.
Defense strategy: This involves investing in large, well-established companies that are financially strong. Large-cap companies tend to be less affected by bear markets and gain more in bull markets. Stocks in companies that produce many products that people will always need, such as food processing companies and companies that manufacture consumer staples such as toiletries, are good investments. These financially sound companies are more likely to survive downturns.
Investing in consumer staples Exchange Traded Funds (ETF) that hold stocks of many companies in that industry can be a good strategy. They will be less risky, as it offers more diversification than investing in a single stock.
Investing in stocks that pay dividends is also a good idea and will make bearish markets less painful. High-quality bonds also are a smart investment during a volatile market because bond prices often move in the opposite direction of stock prices.
Bargain shopping: Buying more stocks at lower prices can be another successful investment strategy during a bearish market. The best way to go about this is called dollar-cost averaging. This is when investors regularly invest money over time, in roughly equal amounts, regardless of the market conditions. This helps smooth out the purchase price over time, ensuring investors do not put all their money into a stock when it is high (while still taking advantage of market dips).
Bear Market History
1929-1932 The Great Depression Bear Market: This was one of the worst market declines ever. The S&P 500 declined by about 86% in less than 3 months. It peaked at 31.86 and fell to 4.4. This was due to the stock market crash, followed by an asset bubble caused by the financial invention known as ‘buying on margin.’ Through this strategy, investors could borrow money from their brokers and put down only 10 to 20% of the stock value. When a scandal broke out in the British stock market, investors lost confidence in the U.S. stock market, thus triggering the crash.
May 1946 – June 1949: After World War II, stock prices peaked and began a long slide. The postwar demand declined, and Americans put their money into savings. This resulted in the “inventory recession” in 1948. The S&P 500 dropped to 13.55 and lost about 30% during these 37 months.
December 1961 – June 1962: The Kennedy Slide of 1962, also called the Flash Crash, is the term given to the stock market decline from December 1961 to June 1962. The S&P dropped to 52 and lost 28% in a little over 6 months.
November 1968 – May 1970: Inflation and the growing concern about the escalating conflict in Vietnam triggered this bear market. The S&P 500 dropped to 69 and lost 36% in a little under 18 months.
January 1973 – December 1974: This was the worst stock market downturn since the Great Depression. Contributing factors to this decline were the decision taken by President Richard Nixon to end the gold standard, leading to a period of inflation, and the Watergate Scandal. As a result, the S&P dropped to 62 and lost 48% in 21 months.
November 1980 to August 1982: The Fed raised interest rates to nearly 20 percent, which resulted in a recession. The S&P dropped to 101 and lost 27% in 20 months.
March 2000 – October 2002 Bear Market: On the heels of the best bull market came the 2000 Bear Market. The decline began before a recession even had started. A loss of investor confidence in stock valuations that had reached new historic highs caused the dot-com bubble to burst. Together with the 9/11 attacks and a series of U.S. accounting scandals, this led to the 2001 recession. The Nasdaq composite index, which soared in value thanks to hundreds of tech start-ups’ listings, plunged 50% in nine months. The S&P dropped to 777 and lost 49% in 30 months.
October 2007 – March 2009: This was the second-worst bear market in terms of percentage decline in history. Between October 2007 and March 2009, the S&P 500 fell by approximately 50%. This was caused by the 2008 stock market crash, the failure of the Lehman Brothers due to the continuing subprime mortgage crisis, and Congress’ reluctance to pass a bailout. Simultaneously, the government launched an economic stimulus plan in 2009, causing investor confidence to drop further. As a result, the S&P dropped to 683 and lost almost 57% in 17 months.
February 2020 – April 2020: Global stocks entered into a sudden bear market in the wake of the global coronavirus pandemic. The bear market started on February 19, 2020, and in a little more than a month, the COVID-19 pandemic caused the S&P 500 to decline by 33.9%. This bear market was the shortest in history. According to CFRA Research, it lasted only 33 days. A new bull market started on March 23, 2020.
Bear markets are upsetting events for most investors. After all, a bear market defines a time when the asset class is down by more than 20% for a period of more than 2 months.
When a market becomes bearish, investors start to feel anxious about their investments and their financial future. It is essential for investors not to panic when things start to take a downward turn. Investors should maintain their composure and look past economic, psychological, and consumer behavior that often arises during a market decline. Bear markets are normal and are part of the economic cycle.
Bear markets are a fact of life. However, it is tough to anticipate when they start, know how long they will last, or how low the market will go. The good news is that after every bear market comes a bull market.
It is normal for investors to be cautious in a declining financial market. However, investors who are too cautious and sell all their investments will miss opportunities to benefit from future growth.
The best way to overcome a bear market is to learn from past market declines and be proactive about diversification. This way, investors can position themselves to reduce their portfolio losses and even make some money off the declining market.
Defining and Dating Bull and Bear Markets: Two Centuries of Evidence is a great research paper that discusses bull and bear markets.