Last Updated on 17 October, 2020 by Samuelsson
If you have been following the market for a long time, you must have noticed that there are different phases in the market. The market can be bullish at one time and bearish at another, but is a bear market such a bad thing?
Bear markets are bad for investors who are long in the market and good for investors who are short in the market. However, because it is difficult to predict the beginning of a bear market and when it would end, most investors get caught up in it before they could plan for it.
There are a lot of things you may not know about bear markets. To learn more about them, keep reading!
What is a Bear market?
A bear market is a phase in the market cycle when prices of stocks are generally going down for an extended period of time. That is, the market is in a downward trend. Traditionally, a bear market is said to occur when there is a market decline of about 20% or more from a previous peak, which lasts for more than two months.
So if there’s only a 15% decline from a previous high, it wouldn’t qualify for a bear market. Similarly, a decline of more than 20% occurring in less than two months wouldn’t be seen as a bear market — the reason why the December 2018 decline wasn’t a bear market.
It is important to note that market performance is measured by important market indices, such as Standard & Poor 500 (S&P 500) and Dow Jones Industrial Average (DJIA). Individual stocks can be in a downward trend for months and years without the market being in a bearish phase.
Historically, bear markets don’t last that long when compared to bull markets. On the average, bear markets last about 16 months compared to bull markets that last more than nine years. However, stock prices depreciate faster in a bear market than they appreciate in a bull market.
Do you know why a declining market is called a bear market? Wall Street believes it came from the way a bear strikes its paw downwards when attacking prey. So a downward trend in the market is known as a bearish trend, and investors who have a negative sentiment about the market are called bears.
Why Do Bear Markets Occur?
Just like the economy, the market is cyclical: uptrend and downtrend. A bullish market will inevitably be followed by a bear market. A lot of factors can trigger a bear market. Here are some of them:
Change in Economic Condition
The stock market and the economy are intrinsically related because the stocks that trade on the market belong to the businesses which make up the major part of the economy. When the economy is weak, businesses don’t make enough profits since consumers don’t spend as they ought to. The reduction in profit will inevitably affect the values of stocks, thereby leading to a fall in stock prices.
A sudden rise in the price of commodities can affect the prices of other goods and services in a significant way, leading to high inflation. Commodities are edible goods and industrial raw materials, such as oil, corn, wheat, steel, etc. When their prices are high, the economy is affected, as well as the stock market.
Aggressive Government Policies
The government controls the economy through its fiscal and monetary policies. In an attempt to control inflation, central banks, such as the Federal Reserve, raise interest rates. But, if the rate hike becomes too much for the economy, there may be a decline in the economy which would drag the stock market with it.
Overvaluation of Stocks
Sometimes, stocks may get extremely overvalued, and the inevitable consequence is a fall in price. This often comes in the form of market corrections, but a correction may be severe enough to kick in a bear market. A common way of checking the value of stocks is by calculating their P/E ratios.
Ultimately, stocks are traded by human beings, and stock price movement reflects human emotions — fear and greed. If the dominating investors’ sentiment is negative, a bear market might set in because market sentiments affect the demand and supply of stocks.
Are there ways to benefit from a Bear Market?
A bear market is not entirely a bad thing; it is a necessary part of the market cycle. What hurts investors during a bear market is their emotions and lack of planning, which often lead them to make poor investment decisions.
It is very necessary to have an investment strategy and a plan for a bear market. An investor who has a plan for a bear market will be ready to play the market when it comes. Here are some ways to approach a bear market:
A good investor would always have a diversified portfolio even before a bear market sets in. It pays to have a certain percentage of your portfolio in safer fixed income securities and cash. When a bear market comes, it may be wise to increase your fixed income securities and hold more cash.
Buying Dividend-Paying Stocks
The price of most, if not all, stocks go down in a bear market, and since good stocks often recover when the bad times are over, bear markets offer great opportunities to own stocks in dividend-paying blue chip companies. These are companies whose stocks were expensive prior to the bear market.
Going Short on Bad Stocks
Some stocks with poor fundamentals can fall badly during a bear market. Some nimble investors go short on such stocks during this period. This may be risky though, as price movement can be highly unpredictable, and if the stock’s price goes up, the loss is potentially unlimited. A better way to do it is to buy long put options, which gives the same potential for profits if the stock keeps falling but limits the amount lost if the stock goes up.
Writing a Put Option on a Blue Chip Stock
During bear markets, some experienced investors write a put option on a good stock they want to buy (at the price they plan to buy it), instead of buying it straight away. They get to earn a premium for buying a stock they already want to buy.
For most investors, stocks would have fallen significantly in price before they could realize there’s a bear market. If you find yourself in that situation and those are good stocks, it may be wise to hold them through the bear market. The bear market will eventually give way to a bull market, and good stocks will always rebound and move higher.
Do You Know What a Bull Market Is?
A bull market is that period in the market cycle when stock prices are trending up. Traditionally, it is defined as a market rally — S&P 500 and DJIA market indices — of more than 20% from a prior low, lasting more than eight months.
History shows that bull markets last longer than bear markets, with an average bull market lasting about 4,5 years.
If you’re curious, the term bull market is believed to come from the way a bull surges upwards during an attack.
Markets move in cycles; a bear market will always be followed by a bull market and vice versa. Bear markets are not inherently bad, and with adequate planning, you can always come out on top even when the market is going down.
If you enjoyed this article you might also like our other articles answering common questions traders have!