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What is Bear Market?
A bear market is when the market faces declines for an extended period of time. Typically, a bear market is when prices drop 20% or more from the most recent high for over two months.
The causes of a bear market are varied and complex – but all bear markets in the past have been associated with negative investor sentiment.
Downturns in the market are an unavoidable part of the economic cycle, so understanding what it is and how to best plan your investments and finances to handle the inevitable bear market is important.
Understanding Bear Markets
To understand how a bear market happens, we first need to understand how the stock market works.
The price of any stock on the stock market reflects what the investors expect from it in the future. If the sentiment towards any stock is positive, more investors will want to buy it, pushing its price up.
On the other hand, if there is a widespread negative sentiment towards a stock, investors will want to sell it off, leading the stock price to fall. This fall in prices for an extended period of time, typically more than 2 months, is a bear market.
Another way to look at a bear market is when investors are more risk-averse than risk-seeking. In times of economic turmoil and uncertainty, people generally do not want to take on any more risk. They pull out all the money they invested into the stock market, causing prices to fall.
Bear Market vs Bull Market
A bear market is characterized by investor pessimism, economic contraction and low trading volumes.
It is said that the term “bear” is used to describe this market because the downward trend of the market is similar to the downward motion of a bear when it swipes with its paws.
On the other hand, a prolonged period of investor optimism, economic growth and high trading volumes is called a bull market. The term “bull” is used to describe this market because the upward trend of the market is similar to the upward motion of a bull when it attacks with its horns.
Causes of a Bear Market
There is no consensus on the exact causes behind a bear market since the stock market is very complex.
Bear markets happen because of external economic factors, like natural disasters, policy changes, wars, drastic societal changes and more.
The only common factor between all the causes of a bear market is that they are external to the market itself – larger macroeconomic factors that an individual has no control over.
The most recent bear market was in 2020, caused by the COVID-19 pandemic – sanctions and restrictions caused investors to lose faith in the market. This was followed by widespread unemployment, recession and a disruption in the supply chain, which further contributed to a drop in investor confidence.
The worst bear market in recent history was in 2006-2008, caused by the real estate bubble bursting in the U.S.
Stages of Bear Markets
There are four stages to a bear market.
Distribution |
During this stage, the market is still at a high point. Following some external circumstances, some investors start selling their shares, leading to a decline in prices. Market sentiment is still largely positive at this stage. |
Panic |
As macroeconomic factors continue to affect more people, prices will continue to fall as fear and panic set in among investors. This phase has high trading volume and steep price declines. |
Capitulation |
In this stage, even long-term investors start selling their shares, leading to a sharp drop in prices. This phase marks the bottom of the bear market, as many investors give up on the market and move their money to other asset classes. |
Speculation |
At this stage, as the macroeconomic conditions begin to improve, people might re-enter the market and invest speculatively. This fresh influx of capital helps the market begin recovery. |
Recovery |
Finally, the market starts to recover, and prices begin to rise.
The recovery phase is often characterized by cautious optimism, as investors gradually return to the market and start buying again. |
Corrections vs Bear Markets
A bear market is a downward trend that goes on for more than 2 months. A correction is any downward trend in the market that only lasts for less than 2 months.
It is caused by temporary macroeconomic factors that can be corrected quicker than the larger issues that cause a bear market.
A correction is actually a good opportunity since it offers an entry point for investors to enter the market and buy stocks at low prices. However, buying new shares during a bear market could be very risky since there is no way to know when the bear market will end.
For example, if an investor had incorrectly identified the initial stages of the COVID-19 pandemic as a market correction instead of the beginning of a bear market, she would have bought stocks that could have caused huge losses to her in the coming year.
This makes it important to differentiate between a correction and a bear market – it requires a detailed analysis of market trends, indicators and historical data to understand if this particular macroeconomic factor will lead to a correction, or will extend into a bear market.
Example of Bear Market: Financial Crisis of 2008
In 2008, many subprime mortgages in the United States were issued to borrowers who couldn’t afford them. When the housing market collapsed, many homeowners defaulted on their mortgages, leading to a wave of foreclosures.
As a result, banks and financial institutions that had invested heavily in these subprime mortgages faced significant losses, triggering a broader financial crisis. The stock market plummeted, and many investors lost a substantial amount of money. The Dow Jones Industrial Average, for example, lost over 50% of its value between October 2007 and March 2009.
This period of a sustained and significant decline in the stock market is a classic example of a bear market. It lasted for several months and had a profound impact on the global economy, leading to high unemployment rates, reduced consumer spending, and a significant slowdown in economic growth.
How to Get Through a Bear Market
Both individual investors and businesses need to know how to manage investments as efficiently as possible to reduce the effects of a bear market on their finances.
If not done correctly, it can lead to losses and worsen the already bad situation. Here are a few pointers on how to manage your finances best in times of economic turmoil.
Diversify your Investments
One of the best ways to minimize risk is to diversify your portfolio across different asset classes, such as stocks, bonds, and cash. This can help you weather market downturns and avoid putting all your eggs in one basket.
Read more: Diversify Your Portfolio
Stay the Course
During a bear market, it’s important to resist the urge to sell off your investments in a panic. Instead, focus on your long-term investment goals and stay the course, knowing that markets go through cycles and eventually recover.
Add to your Investments
A bear market can present opportunities to buy high-quality stocks at discounted prices. If you have cash reserves or are able to free up some funds, consider adding to your investments during market downturns to take advantage of potential future gains.
Consult with a Professional
If you’re uncertain about how to manage your investments during a bear market, consider seeking professional financial advice. A financial advisor can help you develop a personalized investment strategy based on your risk tolerance, investment goals, and financial situation.
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FAQs
What is a bear market?
A bear market is a prolonged period of declining stock prices, often accompanied by investor pessimism and a weak economy. During a bear market, many investors may panic and sell off their stocks, leading to further declines in prices.
What is a bear and bull market?
A bear market is a prolonged period of declining stock prices. A bull market is the exact opposite - a prolonged period of rising stock prices.
Is it good to buy in a bear market?
In a bear market, stock prices are typically lower, which can create buying opportunities for long-term investors. However, it's important to do your research and only invest in companies that you believe have strong fundamentals.
