What is a bear market?
A bear market refers to a prolonged period of falling prices in the stock market. It is typically defined as a decline of 20% or more from a previous peak. Bear markets are the opposite of bull markets, when prices are rising. Some key characteristics of bear markets include:
- Falling stock prices – The hallmark of a bear market is an extended decline in stock prices across the market.
- Investor pessimism – Investor sentiment is generally negative during bear markets. There is widespread fear and uncertainty.
- Decreased trading volumes – As investors become more risk averse, trading volumes tend to decline in a bear market.
- Market corrections – Bear markets are usually associated with sharp market corrections as investors panic and sell shares.
Bear markets can occur as part of the normal business cycle. Sometimes they are triggered by specific events like recessions, wars, or financial crises. The most recent bear market began in March 2020 as the Covid-19 pandemic impacted the global economy. Prior to that, the last bear market was during the 2007-2009 financial crisis.
Why do bear markets occur?
There are a few common reasons bear markets occur:
- Economic factors – Rising inflation, high interest rates, recessions and downturns in consumer and business spending can all contribute to bear markets.
- Geopolitical events – Wars, conflicts, or political instability can negatively impact the stock market and cause bear markets.
- Financial crises – Events like the housing crisis of 2008 or dot-com bubble bursting in the early 2000s can wipe out investor confidence and lead to bears.
- Investor psychology – Greed in bull markets can eventually flip to fear. Herd mentality kicks in as investors panic and sell-off shares.
Essentially, bear markets indicate the market cycle is transitioning from a period of growth into a period of decline. While they can occur unexpectedly, most bear markets are preceded by warning signs like high stock valuations, rising interest rates, and slowing economic growth.
How long do bear markets last?
There is no set duration for bear markets. Historically they have tended to last between 9 months to 2 years. Here are some examples of the duration of recent bear markets:
- March 2020 bear market – 1 month
- 2007-2009 bear market – 17 months
- 2000-2002 dot-com bubble bear market – 29 months
- 1990 bear market – 3 months
The length and severity of a bear market depend on various economic and market factors. Quick bear markets are often triggered by short-term events like geopolitical conflicts or financial shocks. More structural or cyclical bear markets associated with recessions tend to last longer.
Given high valuations, many experts predict the next bear market could rival the 2007-2009 bear which lasted nearly 1.5 years. However, government interventions like monetary stimulus could potentially shorten the duration.
What are the stages of a bear market?
Bear markets tend to unfold across three broad stages:
Stage 1: Distribution
In this early stage, leading stocks start to decline as experienced investors begin selling positions to lock in profits from the previous bull market. The overall indexes remain stable however as sentiment remains fairly optimistic. This distribution phase can last several months before any real bear trend emerges.
Stage 2: Price Decline
The bull market definitively turns into a bear as sustained selling accelerates market declines. Stocks fall rapidly across sectors. Investor sentiment is increasingly fearful. Trading volumes spike as investors panic and sell-off positions. This decline phase is the most painful stage for long-term holders.
Stage 3: Despondency
In the final depressive phase, stock declines slow as prices reach lows on weak volume. Sentiment is dominated by pessimism and assumptions things will get worse. Bear market rallies with brief upswings may occur but ultimately fail to turn the overall trend around.
Recognizing these bear market stages can help investors understand where they are in the current downcycle and make appropriate decisions.
What are the dos and don’ts of navigating a bear market as an investor?
Here are some key dos and don’ts for investors to keep in mind during bear markets:
Don’t panic and sell indiscriminately
Bear markets can tempt investors to react emotionally and sell quality holdings at the worst possible time. But trying to time bear markets is exceptionally difficult. It’s better to hold through the downturn.
Do maintain proper diversification
Ensure your portfolio is properly diversified across asset classes, geographies, sectors and risk profiles. This cushion helps mitigate against downside risk.
Don’t try to catch falling knives
Avoid the temptation to buy beaten down stocks that seem cheap during bear markets. Often valuations fall further or companies fail to recover.
Do review your investment time horizons
Make sure your investing time frame aligns with your goals. You’re less prone to irrational moves if you don’t need funds in the near term.
Don’t leverage or use margin excessively
Using borrowed money like margin accounts amplifies losses in bear markets. Investors can get wiped out. Manage leverage carefully.
Do consider rebalancing your portfolio
Revisit your target asset allocation and rebalance back to original ratios. This allows buying undervalued assets.
How can investors protect themselves during bear markets?
Here are five strategies investors can use to help protect capital during bear markets:
Hold adequate cash reserves
Having sufficient cash reserves provides stability and allows snapping up bargains during declines. Aim for at least 6 months of cash buffer.
Use defensive assets like bonds
High-grade bonds hold up better during stock downturns. Longer-term bonds provide principal protection when yields drop.
Diversify across assets, sectors and geographies
A globally diversified portfolio reduces concentration risk and volatility during localized bear markets.
Invest in bear market resilient sectors
Defensive sectors like healthcare and consumer staples tend to outperform during bear markets.
Hedge with options strategies
Options like put spreads help hedge against further index declines. Protective puts lock in profits.
What are the common bear market mistakes investors should avoid?
Here are some of the biggest mistakes investors make during bear markets and how to avoid them:
Panic selling quality assets
Bear markets test investor resolve. But giving in to fear and selling quality holdings at market lows locks in losses and prevents benefiting from eventual rebounds.
Avoidance Strategy: Stay disciplined on valuations and long-term fundamentals.
Trying to time the market
No one can predict the exact market bottom. Jumping in and out of positions often backfires.
Avoidance Strategy: Dollar cost average into positions over time.
Using excessive leverage
Borrowing to buy stocks is risky in bull markets, and even more dangerous in bears. Leverage amplifies losses if prices drop further.
Avoidance Strategy: Reduce margin debt and use leverage judiciously.
Catching falling knives
Stocks that have crashed in price during a bear market often fall further. Buying declining momentum stocks is risky.
Avoidance Strategy: Wait for fundamentals to stabilize before buying battered down stocks.
Failing to rebalance
Rebalancing forces selling high and buying low. Refusing to do so out of fear of selling winners could hurt long-term returns.
Avoidance Strategy: Revisit asset allocation targets regularly and rebalance.
What are the signs a bear market may be ending?
It’s difficult to call the end of a bear market in real-time, but some signs indicate the bottom may be near:
- Major indexes like the S&P 500 are down 20% from peaks
- Investor sentiment reaches extreme pessimism
- Stocks fall on low trading volume
- Fundamentals improve for leading stocks
- Technical indicators reach oversold levels
- Economic data starts improving
Bear market rallies also tend to occur before the final trough. These sharp counter uptrends signal investors expect conditions to stabilize. But the rally usually fails to hold.
Even once a bear market bottom is in place, stocks tend to recover slowly initially. Patience is key, as it takes time for uptrends to build momentum. The initial gains when a bear flips to a bull market offer the biggest rewards.
How should investors prepare for the next bear market?
Here are some steps investors can take to prepare for the inevitability of the next bear market:
- Build up sufficient cash reserves – Having cash protects against liquidity shocks and provides funds to deploy into bargains when stocks decline.
- Pay down high interest debt – Eliminate liabilities with double-digit interest rates so they aren’t weighing you down when markets fall.
- Review risk tolerance – Gauge your ability to endure periods of negative returns without panicking. Don’t take on more risk than appropriate.
- Ensure proper diversification – Reduce concentrated positions and balance across varied assets classes, sectors, geographies, etc.
- Identify defensive holdings – Seek out stocks with pricing power, low valuations, stable revenue streams and solid dividends to smooth volatility.
The ability to shelter from bear market storms relies on taking the right steps before markets peak. Developing a prudent plan and executing it in a disciplined fashion is critical to long-term investment success across market cycles.
Conclusion
Bear markets are inevitable and painful phases of the overall market cycle. While timing them is impossible, investors can avoid costly mistakes by focusing on controlling behaviors and risk management. Maintaining perspective and avoiding reactionary moves helps portfolios endure bear markets and capture rebounds when the bulls return. Patience and discipline ultimately pay off.
