Bear Market Guide: Definition, Phases, Examples & How to Invest During One (2024)

Bear Market Guide: Definition, Phases, Examples & How to Invest During One (1)

What Is a Bear Market?

A bear market is when a market experiences prolonged price declines. It typically describes a condition in which securities prices fall 20% or more from recent highs amid widespread pessimism and negative investor sentiment.

Bear markets are often associated with declines in an overall market or index like the S&P 500, but individual securities or commodities can also be considered to be in a bear market if they experience a decline of 20% or more over a sustained period of time—typically two months or more. Bear markets also may accompany general economic downturns such as a recession. Bear markets may be contrasted with upward-trending bull markets.

Key Takeaways

Bear markets occur when prices in a market decline by more than 20%, often accompanied by negative investor sentiment and declining economic prospects.
Bear markets can be cyclical or longer-term. The former lasts for several weeks or a couple of months and the latter can last for several years or even decades.
Short selling, put options, and inverse ETFs are some of the ways in which investors can make money during a bear market as prices fall.

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.

One definition of abear marketsays markets are in bear territory when stocks, on average, fall at least 20% off their high. But 20% is an arbitrary number, just as a 10% decline is an arbitrary benchmark for a correction. Another definition of a bear market is when investors are more risk-averse than risk-seeking. This kind of bear market can last for months or years as investors shun speculation in favor of boring, sure bets.

The causes of a bear market often vary, butin general, a weak or slowing or sluggish economy, bursting market bubbles, pandemics, wars, geopolitical crises, and drastic paradigm shifts in the economy such as shifting to an online economy, are all factors that might cause 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.

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.

"Bear" and "Bull"

The bear market phenomenon is thought to get its name from the way in which a bear attacks its prey—swiping its paws downward. This is why markets with falling stock prices are called bear markets. Just like the bear market, the bull market may be named after the way in which the bull attacks by thrusting its horns up into the air.

Bear Markets vs. Corrections

A bear market should not be confused with a correction, which is a short-term trend that has a duration of fewer than two months. While corrections offer a good time for value investors to find an entry point into stock markets, bear markets rarely provide suitable points of entry. This barrier is because it is almost impossible to determine a bear market's bottom. Trying to recoup losses can be an uphill battle unless investors are short sellers or use other strategies to make gains in falling markets.

Between 1900 and 2018, the Dow Jones Industrial Average (DJIA) had approximately 33 bear markets, averaging one every three years. One of the most notable bear markets in recent history coincided with the global financial crisisoccurring between October 2007 and March 2009. During that timethe Dow Jones Industrial Average (DJIA) declined 54%. The global COVID-19 pandemic caused the most recent 2020 bear market for the S&P 500 and DJIA. The Nasdaq Composite most recently entered a bear market in March 2022 on fears surrounding war in Ukraine, economic sanctions against Russia, and high inflation.

Short Selling in Bear Markets

Investors can make gains in a bear market by short selling. This technique involves selling borrowed shares and buying them back at lower prices. It is an extremely risky trade and can cause heavy losses if it does not work out. A short seller must borrow the shares from a broker before a short sell order is placed. The short seller’s profit and loss amount is the difference between the price where the shares were sold and the price where they were bought back, referred to as "covered."

For example, an investor shorts 100 shares of a stock at $94. The price falls and the shares are covered at $84. The investor pockets a profit of $10 x 100 = $1,000. If the stock trades higher unexpectedly, the investor is forced to buy back the shares at a premium, causing heavy losses.

Puts and Inverse ETFs in Bear Markets

A put option gives the owner the freedom, but not the responsibility, to sell a stock at a specific price on, or before, a certain date. Put options can be used to speculate on falling stock prices, and hedge against falling prices to protect long-only portfolios. Investors must have options privileges in their accounts to make such trades. Outside of a bear market, buying puts is generally safer than short selling.

Inverse ETFs are designed to change values in the opposite direction of the index they track. For example, the inverse ETF for the S&P 500 would increase by 1% if the S&P 500 index decreased by 1%. There are many leveraged inverse ETFs that magnify the returns of the index they track by two and three times. Like options, inverse ETFs can be used to speculate or protect portfolios.

Tips For Retiring In A Bear Market

Real-World Examples of Bear Markets

The ballooning housing mortgage default crisis caught up with the stock market in October 2007. Back then, the S&P 500 had touched a high of 1,565.15 on October 9, 2007. By March 5, 2009, it had crashed to 682.55, as the extent and ramifications of housing mortgage defaults on the overall economy became clear. The U.S. major market indexes were again close to bear market territory on December 24, 2018, falling just shy of a 20% drawdown.

Most recently, the Dow Jones Industrial Average went into a bear market on March 11, 2020, and the S&P 500 entered a bear market on March 12, 2020. This followed the longest bull market on record for the index, which started in March 2009. Stocks were driven down by the onset of the COVID-19 pandemic, which brought with it mass lockdowns and the fear of depressed consumer demand. During this period, the Dow Jones fell sharply from all-time highs close to 30,000 to lows below 19,000 in a matter of weeks. From February 19 to March 23, the S&P 500 declined 34%.

Other examples include the aftermath of the bursting of the dot com bubble in March 2000, which wiped out approximately 49% of the S&P 500's value and lasted until October 2002; and the Great Depression which began with the stock market collapse of October 28-29, 1929.

As an experienced financial analyst and market enthusiast with a deep understanding of market dynamics, let me delve into the concepts discussed in the provided article on bear markets.

Bear Market Overview:

A bear market is characterized by prolonged price declines of 20% or more from recent highs, accompanied by widespread pessimism and negative investor sentiment. This phenomenon is not exclusive to overall markets like the S&P 500; individual securities or commodities can also be considered in a bear market under similar conditions.

Key Takeaways:

Definition of Bear Markets:
- Occur when prices decline by more than 20%.
- Often associated with negative investor sentiment and economic downturns.
Duration and Types of Bear Markets:
- Can be cyclical (lasting weeks to months) or longer-term (lasting years or decades).
- Secular bear markets may span 10 to 20 years with below-average returns.
Causes of Bear Markets:
- Factors include weak economies, market bubbles bursting, pandemics, wars, geopolitical crises, and drastic economic paradigm shifts.
- Signs include low employment, low disposable income, weak productivity, and a drop in business profits.
- Government interventions, changes in tax rates, and shifts in investor confidence can trigger bear markets.

Phases of a Bear Market:

First Phase:
- High prices and investor sentiment.
- Investors start exiting markets and taking profits.
Second Phase (Capitulation):
- Stock prices fall sharply.
- Trading activity and corporate profits decline.
- Economic indicators become below average, leading to panic.
Third Phase:
- Speculators enter the market, raising some prices and trading volume.
Fourth Phase:
- Stock prices continue to drop slowly.
- Low prices and positive news attract investors, leading to the transition to bull markets.

Bear and Bull Market Origins:

The terms "bear" and "bull" are derived from the way animals attack. A bear market reflects a bear swiping its paws downward, while a bull market mirrors a bull thrusting its horns upward.

Bear Markets vs. Corrections:

A bear market is distinct from a correction, which is a short-term trend lasting fewer than two months.
Corrections may offer entry points for value investors, but bear markets pose challenges in determining their bottom.

Short Selling in Bear Markets:

Investors can make gains in bear markets through short selling.
Short selling involves selling borrowed shares and buying them back at lower prices.
It is a risky trade with potential heavy losses if the market moves unexpectedly.

Puts and Inverse ETFs in Bear Markets:

Put Options:
- Give the owner the right to sell a stock at a specific price before a certain date.
- Used to speculate on falling stock prices or hedge against such declines.
Inverse ETFs:
- Designed to move in the opposite direction of the tracked index.
- Can be leveraged to magnify returns or used for speculation or portfolio protection.

Real-World Examples:

Global Financial Crisis (2007-2009):
- Dow Jones Industrial Average (DJIA) declined 54%.
COVID-19 Pandemic (2020):
- DJIA and S&P 500 entered bear markets in March 2020.
Dot-com Bubble Burst (March 2000 - October 2002):
- S&P 500 lost approximately 49% of its value.
Great Depression (1929):
- Started with the stock market collapse on October 28-29, 1929.

Understanding these concepts is crucial for investors to navigate and respond appropriately to the dynamic nature of financial markets, especially during challenging bear market conditions.