Bear Market - How and Why They Occur

Posted on Monday, October 22nd, 2018 MarketBeat Staff

It’s easy to be in the market when stocks are rising. It can be a little more challenging when stocks are declining. When investor sentiment turns negative, there tends to be a cascading effect where the momentum of the market trends negative. What can be particularly concerning for novice investors is the downward force of a bear market can be just as strong as the upward momentum of a bull market.

In this article, we’ll define a bear market and review the economic characteristics that are in place during such a cycle. We’ll also review the psychology behind a bear market and how it impacts consumer behavior. We’ll also go over how to invest in a bear market and why it’s important to do so.

What is a bear market?

A bear market is defined as a market that declines by 20% or more over at least a two-month timeframe. A bear market historically follows a bull market. In some cases, but not always, a bear market is an indicator that the economy is in recession.

Although a bear market is usually defined as a decline in stock prices, a bear market can occur with any specific asset class. For this reason, it's important to distinguish between a bear market and a correction. Corrections happen much more frequently than bear markets. In fact, corrections occur frequently within bull markets. Because a bear market is marked by a time period of at least two months, it's not surprising that one of the characteristics that distinguish a bear market from a correction is the length of time. Because bear markets require specific conditions to be met, it can be difficult to say with certainty that the economy is in a bear market until it is already ongoing.

What are the economic characteristics of a bear market?

A bear market is a sign of a weak and contracting economy. During a bear market, unemployment is on the rise and gross domestic product (GDP) is usually considered to be weak. When investors start to see a rise in unemployment and jobless claims or a declining GDP, they can look at them as leading indicators that a bear market may be coming. However, these indicators are not always historically accurate. Certain sectors and equities (e.g. defensive stocks) can post positive gains even during a bear market. Therefore investors that are suspecting that a bear market is coming will look at earnings reports for indicators such as companies that are reporting declining quarterly revenues and profits. These will usually be a sign for investors to sell, or at least hold, a stock that they have. Also, when corporations are suspecting that the market is about to head into a bearish cycle, they will be less inclined to issue initial public offerings (IPOs).

One of the easiest ways to understand bear markets is through the economic principle of supply and demand. When there is low demand (i.e. a small pool of buyers) for a particular product or service, but there is ample supply in a store, the price generally goes down to incent buyers to buy. As consumers, you see this when you go grocery shopping or why the day after Christmas is a great time to buy next year's decorations. When supply exceeds demand, prices will go down until demand matches supply.

The same principle is evident during a bear market. As investors begin to lose confidence in the market, they may look to sell securities that are not performing well and buy other assets such as bonds or even move money into cash. But those looking to sell their shares are fighting two problems, a lack of buyers and other investors who are already selling. This drives the price per share down.  As a result, sellers will have to accept a lower price (and sometimes a loss) on their shares in order to exit a position they may have. Markets, however, do not move in the same direction all the time. Even in the midst of a bear market, individual stocks may go up, the broader market may go up, but in general, these are just pausing as the market seeks to find a bottom.

The psychology behind a bear market

If the psychology behind a bull market is the fear of missing out, the psychology behind a bear market could be described as the fear of staying in. Many investors know, in their mind, that bull and bear markets – no matter how long they last – are temporary events. Unless an investor is making a living as a day trader, there is logic to staying invested in the market. But investors have different risk tolerances and when the market starts to decline, many investors flee to the safety of less risky assets as a way of protecting their portfolio. Once this sell-off starts, momentum builds as more and more investors flee the particular asset class, causing prices to drop even further.

On the bright side, psychology may also play a role in why bear markets tend to be of shorter duration than bull markets. As a bear market reaches its trough, investors – particularly institutional investors – will start to buy stocks that they recognize as being undervalued. This, in turn, can act as a signal to retail investors that the time is right to begin getting back into the market or buying again if they were holding their assets. If other fundamental and technical indicators align, this can cause stocks to rise, often at a rapid clip. This is one reason why virtually every bear market is immediately followed by a bull market.

Buyer behavior in bear markets

One of the defining features of a bull market is an overall lack of consumer confidence. When consumers fear they may lose their job, or that wages may be flat or even declining due to inflation, they will curb their spending. Although some sectors are less affected (after all, people have to eat, pay their utilities and have gas in their car, it can have negative effects on bigger ticket items. Typically real estate and automobile sales decline in a bear market as consumers are more likely to hang onto the house and car they have then look for something new. From the perspective of a company, the lack of consumer spending slows down production which can mean a downsized workforce and lower revenues and profits. When companies report lower earnings, investors have less incentive to buy their stock.

How to invest in a bear market

The worst thing an investor can do during a bear market is to sell everything. The fact is that for many investors, particularly those who have a long investment horizon, bear markets are short in relation to bull markets. This means that over time, the market has always reached higher highs. Many investors make regular contributions to a 401(k) directly from their paycheck. Although the temptation during a bear market may be to decrease or stop your contribution altogether, a better option may be to maintain your existing contribution. When the price of a share of stock, or mutual fund, decline in value, investors get an opportunity to buy stocks at a great discount. This is only true, however, if you are dealing with stocks of high quality. Generally speaking, these will be the first stocks to bounce back when investors start seeing them as being undervalued. Even in a bear market, it’s hard to keep a good stock down for long. The quality companies that have good fundamentals will be rewarded. As an investor, you can profit from a bear market by buying shares in these stocks when they are “value priced”. For investors comfortable with options trading, setting a price target and a stop option can help you lock in gains should a stock start to go down again.  

How frequently do bear markets occur?

If you look at the performance of the S&P 500, there have been eight bear markets since 1926. These bear markets have averaged 4.1 years and the average cumulative loss was -41%. The longest bear market was 2.8 years during the Great Depression. The shortest bear market was just three months long and it happened during the 1980s, a time generally noted for a booming economy. As previously mentioned, contrast the eight bear markets with 11 bull markets during that time. The average bull market spanned 9 years with a cumulative return of 476%. The difference between a -41% return and a 476% return illustrates the importance of staying in the market even when things get a bit rocky.

It’s also worth repeating that a bear market does not always lead an economy into recession. At its core, a bear market is a statistical event based on facts in evidence. While the psychology behind those statistics can lead the economy into a recession, by itself analysts only look at the technical definition of a bear market (i.e. a 20% decline in an asset class over a period of at least two months) to define when a bear market exists.  

The bottom line on bear markets

Bear markets can be upsetting events. A bear market is defined as a time when an asset class, usually stocks, is down by 20% for a period of no less than two months. As a bear market reaches its trough, buying activity is sharply curtailed as investors are either actively selling their securities and shifting money into other assets like bonds or cash that offer a hedge against declining stock prices.

There are economic, psychological and consumer behavior indicators to a bear market. In general, the economy will be going through a period where GDP is declining and unemployment is rising. Psychologically, once a sell-off begins, investors who fear losing gains will begin to sell causing share prices to decline even further. Before and during a bear market consumer confidence and buying behavior is decidedly conservative. Unfortunately, consumer confidence is one of the last things to come around after a bear market ends. 

An investor with a low-risk tolerance may be tempted to "sell everything" when they see certain stocks or funds in their portfolio lose 20% or more of their value. However, when you consider that there have been more bull markets than bear markets in our nation's history and that the gains from these bull markets far outweigh the declines of a bear market, a more prudent course of action is to maintain your buying activity. However, you should be sure you are investing in quality stocks. A bear market is no time for speculation.

 




 

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