What is a bear market?
When you read about the stock market, you often come across references to bulls and bears, but there are no horned nor clawed beasts on Wall Street. These terms are used to describe price movement and expectations of price movement in the future believed to be based on how these animals strike.
Bulls strike by thrusting their horns up and forward, and a bull market is when prices go up. Bears strike by thrashing their claws down. Bear markets are periods when stocks get beaten down.
What distinguishes a bad day on the stock market from a full-blown bear market? Read on to learn more about bear markets and how they work.
What Is a Bear Market?
Bear markets are characterized by a sharp and often prolonged downturn in stock prices. Stocks are said to be in bear market territory when they fall 20% or more from recent highs.
Bear markets can happen in individual stocks and the entire stock market.
For example, any time benchmarks like the Nasdaq composite index, Dow Jones Industrial Average, or S&P 500 index fall 20% or more from recent highs, the overall market is said to be in bearish territory.
Bear markets shouldn’t be confused with market corrections. The key difference between the two is the percentage drop from recent highs. A decline of 10% or more is a correction, while a decline of 20% or more is a bear market.
There are two types of bear markets to watch out for:
- Cyclical. The market is a cyclical machine that’s known for upward and downward movements. In some cases, prices simply get too high, and downward volatility sets in for a short period of time to bring valuations in check. This is called a cyclical bear market.
- Secular. A secular bear market is one that lasts for a sustained period of time, typically several months or even a few years. Secular bear markets, like the one that took place following the financial crisis from 2007 through much of 2009, are often a sign of severe economic hardship.
How a Bear Market Works
Bear markets are nothing new. Financial experts have been following them for more than a century. The analysis of historical bear markets shows they have several factors in common and usually have four clear phases in the bear market cycle.
Factors That Lead to a Bear Market
Multiple factors can cause a bear market. Being aware of these factors helps you be more prepared when one of these events hits. Some of the biggest reasons the bears take control include:
- Economic Concern. Deep structural concerns about the economy can trigger a bear market. One of the best examples of this was the 2020 COVID-19 pandemic. As shutdowns led to closures of many businesses and the pandemic’s impacts on society and everyday life were not yet fully known, corporate profits were called into question, sending stocks spiraling downward.
- Market Bubbles. When the market is too excited about a single sector, bubbles begin to form. These bubbles often have widespread ramifications when they burst. One of the most well-known examples of this is the dot-com bubble.
- Generally High Valuations. Just before a bear market, valuations are typically the highest they’ve been in some time. These high valuations lead to a shift in investor sentiment, sending prices downward.
- Geopolitical Concerns. War can result in economic and supply chain issues among other grim realities. As a result, the market tends to react to the threat of war by falling into bear territory.
These factors can cause bear markets alone or in conjunction with one another. Typically, when a bear market has multiple causes, it becomes a long-term secular bear market.
Phase 1: The “Too Good to Be True” Phase
The first phase of a bear market is when the market is overwhelmingly positive. Speculators push stocks to high valuations, potentially creating bubbles in some sectors. Speculators and savvy investors begin to cash out of their investments when valuations start to get out of control, dumping an excess supply of shares on the open market as they take their profits.
Phase 2: The “Sky Is Falling” Phase (Capitulation)
As investors take profits, investor sentiment shifts from bullish to bearish and prices start to follow a steep path downward as a selloff commences. During this phase, an economic downturn typically takes place and stock prices begin to fall into bear territory.
Phase 3: The Volatility Phase
With prices falling, speculators rush to buy in at the bottom, hoping to enjoy a ride upward. This typically causes brief upward movement and positive volume from time to time throughout the bear market.
Phase 4: The Silver Lining Phase
Declines in prices start to slow toward the end of the bear market. Economic indicators begin to improve and positive news from publicly traded companies combined with a general belief among investors that stocks are undervalued leads to buying in the market, beginning to usher the next bull market in.
Effects of a Bear Market
The most obvious effect of a bear market is on investment portfolios. Stocks you owned before the bears took control can drop, sometimes substantially, leading to significant losses. But the effects of a bear market are often far more widespread than in your portfolio alone. Some of the biggest effects of a bear market include:
- Corporations Lose Access to Funds. When investors are selling shares rather than buying them, they are pulling their capital out of Wall Street. This means many companies begin to be starved of the funding they need to grow.
- Production Slows. With less funding available in the market, corporations begin to curb production goals. If a bear market lasts too long, the entire gross domestic product (GDP) may begin to slump.
- Unemployment. When corporations curb production goals, their need for manpower decreases as well. This can lead to hiring freezes and even layoffs, resulting in higher rates of unemployment.
- Reduced Spending. When consumers are in fear for their financial stability, they’re less likely to spend money. As a result, savings takes precedence over spending, and many people cut back on buying various goods and services. This can potentially cause corporate profits to fall, resulting in further economic hardship.
- Monetary Policy Changes. In some cases, economic concerns become so dire that the U.S. Federal Reserve steps in with monetary policy changes, typically reducing interest rates to spur lending and spending.
What to Do in a Bear Market
Although panic selling is one of the drivers behind many bear markets, it’s one of the worst moves you can make.
Keep in mind, the stock market is cyclical and this isn’t the first time bears are running. If you use historical data as a guide, you can ride out a bear market and protect much of your wealth and may even come out ahead when the bulls take back control.
Consider the following tactics as the bears begin to rush in:
- Adjust Your Allocation. Chances are you’re not as comfortable with risk as you were when the bulls were running. Start by considering your current risk tolerance and adjusting your asset allocation accordingly.
- Consider Shifting Toward Income. Blue chip stocks are typically relatively stable companies that add to their returns by offering meaningful dividend yields. Consider using these stocks as a shelter to ride out the storm.
- Dive Into Safe Havens. Invest in safe-haven asset classes like precious metals and bonds, which are known to be positive stores of value when economic and market conditions are concerning.
- Practice Dollar-Cost Averaging. Take advantage of lower prices by buying now-discounted shares, but do so by practicing dollar-cost averaging, spreading your investments in equal increments over a period of time. This helps ensure you don’t have to accept significant losses if the prices of the stocks and exchange-traded funds (ETFs) you buy fall even further after you begin buying in.
Bear Market FAQs
Bear markets are scary times, especially if it’s your first time going through one. Most things that are scary are generally misunderstood. Answers to a few questions could alleviate much of the fear you have about bear markets.
What’s the Difference Between a Bear Market & a Bull Market?
Bear and bull markets are the two primary cycles of financial markets. Bear and bull markets each follow one another.
The difference between the two is the direction stocks typically take during these cycles. Although short-term declines can happen, stocks head higher overall in bull markets. Conversely, when bears take control, there’s more downward than upward movement.
What’s the Difference Between a Bear Market & a Market Correction?
A market correction is a short-term downward trend that results in a loss of 10% or more. Like bear markets, market corrections can happen on an individual stock or throughout the market as a whole. However, corrections don’t typically have long-term implications — that is, unless they prove to be a prelude to a bear market.
Bear markets, on the other hand, are characterized by a decline of 20% or more from recent highs. Bear market periods tend to last longer than market corrections and can have long-term economic implications.
What Are the Signs a Bear Market Is Coming?
There are a few signs that act as red flags for investors, signaling an incoming bear market. The most common warning signs include:
- High Inflation. High inflation is typically associated with a coming bear market. That’s because the Federal Reserve usually increases interest rates to curb demand and bring balance back to the market when inflation levels get too high. Rising interest rates act like brakes on the economy, slowing it down.
- Economic Slowdown. Corporate profits have a strong correlation to economic conditions. When economists say a slowdown is coming, a bear market may soon follow as investors react to dimming financial data by selling out of their investments.
- Geopolitical Tensions. Conflict or the threat of conflict often carries a heavy cost. For example, war in the middle east could impact oil production, leading to high energy costs and triggering a bear market as consumers spend less on goods and more on energy.
- High Valuations. The market can’t run on excessively high valuations forever. Use valuation metrics like the Shiller P/E ratio to determine whether the market is undervalued, overvalued, or trading at a fair market value. When valuations climb and greed takes control in the market, it’s a sure sign that either a correction or a full-blown bear market is on the horizon.
How Long Do Bear Markets Last?
According to Covenant Wealth Advisors, the average bear market lasts about 342 days. However, bear markets can last anywhere from a few months, like the pandemic-driven bear market of 2020, to well over a year, like the bear market that ran from 2007 through much of 2009.
Although it’s easy to let fear take control in bear markets, it’s likely your worst option. When a bear market takes hold, it’s time to stay calm and assess the situation. Consider the nature of the bear (whether it’s cyclical or secular) and how well your current allocation prepares you. Then do some research and make educated, thoughtful decisions as to what to do next.
With a little creative thinking and willingness to dig to find the most profitable opportunities, you could even come out ahead in a bear market.