Understanding a Bear Market
A bear market is characterized by prolonged price declines in financial markets, typically 20% or more. These downturns often coincide with widespread investor pessimism, large-scale asset liquidation, and weakening economic indicators.
Bear markets generally affect broad indexes like the S&P 500 but can also impact individual securities or commodities if they experience significant declines over a sustained period, usually two months or more. This period of falling prices often accompanies economic downturns, such as recessions, and is viewed as the opposite of upward-trending bull markets.
Key Takeaways
- Bear markets occur when prices decline by more than 20%, coupled with negative investor sentiment and a weakening economy.
- Bear markets can be cyclical or long-term, with the former lasting several weeks or months, and the latter stretching for years or even decades.
- Investors can profit during bear markets through short selling, put options, and inverse ETFs.
Understanding Bear Markets
Stock prices usually mirror investors’ expectations of companies’ future performance. If a company’s growth or profits fall short of predictions, investors may start selling its stock, leading to overall price declines. This herd behavior, along with fear-driven actions to minimize losses, results in prolonged periods of depressed asset prices.
A market is said to be in bear territory when stocks, on average, fall at least 20% from their peak. However, the 20% figure is somewhat arbitrary. Another definition indicates a bear market when investors become more risk-averse than risk-seeking, shunning speculative investments and favoring safer bets, which can last for months or years.
Causes of a Bear Market
Several factors can trigger a bear market, including:
- Weak or sluggish economy
- Bursting market bubbles
- Pandemics
- Wars or geopolitical crises
- Economic paradigm shifts
Signs of a weak or slowing economy include low employment, declining disposable income, weak productivity, and falling business profits. Government interventions, such as changes in tax rates or the federal funds rate, can also precipitate a bear market. A drop in investor confidence often signals the onset of a bear market as investors preemptively sell shares to avoid future losses.
Bear markets can vary in duration. Secular bear markets might last 10 to 20 years with generally below-average returns, marked by intermittent rallies that fail to persist. Cyclical bear markets could last from a few weeks to several months.
Recent Bear Markets
Recent examples include:
- In late 2018, U.S. major market indexes nearly entered bear market territory.
- In March 2020, the S&P 500 and Dow Jones Industrial Average sharply declined due to the COVID-19 pandemic.
- The financial crisis of 2007-2009 saw the S&P 500 lose 50% of its value over 17 months.
Phases of a Bear Market
Bear markets generally unfold in four phases:
First Phase
Characterized by high prices and high investor sentiment, followed by a drift downward as investors begin taking profits.
Second Phase
Sharp price declines occur, accompanied by dropping profits and economic indicators turning below average, leading to investor panic or capitulation.
Third Phase
Speculators re-enter, causing a temporary rise in some prices and trading volumes.
Fourth Phase
Prices drop more slowly, setting the stage for transitioning to a bull market as low prices and positive news attract investors again.
Bear Markets vs. Corrections
Unlike bear markets, corrections are shorter-term trends lasting less than two months, offering value investors suitable entry points. In bear markets, however, identifying the bottom is nearly impossible, making gains tough without strategies like short selling or put options.
Strategies in Bear Markets
Short Selling
Short selling involves selling borrowed shares and repurchasing them at lower prices. Although potentially profitable, it is extremely risky. For example, short-selling 100 shares at $94 and covering at $84 yields a $1,000 profit.
Put Options and Inverse ETFs
A put option allows selling a stock at a specific price before a given date, providing speculation or downside protection. Inverse ETFs move in the opposite direction of their tracked indexes, offering a hedging possibility or speculative advantages.
Real-World Examples
Financial Crisis (2007-2009): Sparked by the housing mortgage default crisis, the S&P 500 plummeted from 1,565.15 in October 2007 to 682.55 by March 2009.
COVID-19 Pandemic (2020): The S&P 500 dropped 34% from February 19 to March 23.
Other notable examples include the dot-com bubble burst in March 2000 and the Great Depression’s onset in 1929.
Investing in Bear Markets
Difference from Bull Markets
While bear markets denote major downturns, bull markets signify upswings in financial markets.
Is It Good to Buy During a Bear Market?
For long-term investors, bear markets can present opportune moments to buy valuable stocks at lower prices, provided they can wait for market rebounds.
Should You Sell Stocks During a Bear Market?
Maintaining a balanced, diversified portfolio may negate the need to sell during bear markets. Selling out of fear might lead to missed profit opportunities during recovery. A buy-and-hold strategy is generally advised.
The Bottom Line
Bear markets illustrate downward trends in financial markets, indicating economic weakness and declining investor confidence. Though challenging, they offer buying opportunities for long-term investors and require specific strategies for short-term gains.
Related Terms: Bull Market, Stock Market, Recession, Economic Downturn, Short Selling, Put Options, Inverse ETFs.
References
- CNBC. “By the Numbers: Stock Market Collapses on Christmas Eve, Heads for Worst December Ever”.
- CNN Business. “Stocks Plunge Into Bear Market Territory: March 12, 2020”.
- Associated Press. “A Look at What Happens When Stocks Enter a Bear Market”.
- The New York Times. “Dow Skids Into Bear Market, Heralding an Uncertain Future”.
- CNBC. “Stock market live updates: Dow wipes out 2020 losses, S&P 500 posts 5-week win streak, best August since 1984?”
- Edward Jones. “Don’t Fear the Bear”.
- Reuters. “Wall St. Slides as Oil Prices Surge, Nasdaq Confirms Bear Market”.
- CNNMoney. “Dow, S&P Break Records”.
- CNNMoney. “Wall Street: Ugly Is Back”.
- CNBC. “Dow Plunges 10% Amid Coronavirus Fears for Its Worst Day Since the 1987 Market Crash”.
- Forbes. “The Coronavirus Stock Market: A Market Gone Wild”.
- CNN Business. “Stocks Are at an All-Time High. Here’s What Stopped the Last 12 Bull Runs”.
- WIRED. “March 10, 2000: Pop Goes the Nasdaq!”
- Federal Reserve History. “Stock Market Crash of 1929”.
