If you read our last lesson, you now know all about bull markets…way to go! Now it’s time to look at the other end of the spectrum, and examine bear markets.
What Is a Bear Market?
A bear market is a pronounced downtrend for a financial market. In this case we’re referring to big drops specifically among key worldwide indexes such as the S&P 500, Dow Jones Industrial Average, or Financial Times Stock Exchange 100, rather to markets that trade bonds, commodities, or other financial assets.
Let’s take a closer look at the key traits of bull markets, and what causes them.
How Do We Know We’re in a Bear Market?
We typically define a bear market as becoming official when stock prices fall 20% or more from any given point. The most recent sustained bear market occurred during the financial crisis of 2007-2009, when the S&P 500 plunged 50% over a period of 17 months.
The biggest bear market of time ran from the stock market crash of 1929 through the Great Depression that ensued all the way to 1932. All told, the S&P 500 lost 86% over that span, and didn’t reach its former highs again until 1954.
Common Traits of a Bear Market
Bear markets can vary in length, sometimes lasting years, sometimes just a few weeks. The 20% loss that signals an official bear market can result from a number of different factors. Those factors can include a slowdown in the economy, negative geopolitical news, slowdowns in corporate profits, interest-rate decisions by the Federal Reserve, an erosion in investor confidence, or even just a drop-off after a prolonged bull market.
Sometimes, an event called a secular bear market can occur. A secular bear market is defined as an extended period of time in which the market yields below-average returns on a sustained basis. Secular bear markets can last for years, or even a decade or more. The market may rally during a secular bear market, but those gains don’t last long, and soon evaporate.
What to Do with Your Stocks in a Bear Market
The simplest strategy during a bear market is to simply reduce your exposure to stocks. The most extreme form of that strategy is selling everything you own and riding out the bad times in cash, commodities, or fixed-income assets such as bonds. You can also choose to sell some of the stocks that you own, but not all of them.
Another approach is to rotate into different kinds of stocks. While growth stocks often perform best during bull markets, more defensive stocks tend to hold up best when bear markets emerge. Water, gas, and electric utilities are examples of defensive stocks, because people need those services regardless of how the stock market or broader economy is performing.
Other Trading Strategies in a Bear Market
A more aggressive approach during a bear market is to engage in short selling. When you sell a stock short, you’re borrowing shares from a broker, then buying them back at lower prices. You make a profit if you short the stock, its price falls after you short it, then you “cover” your position by buying the shares back.
So if you short-sell a stock at $100 a share, then cover your position when the price drops to $80, you’ve made a 20% profit. Just be aware that if the stock rises after you short it, you’ll incur a loss when you cover your position.
Another strategy is to sell a put option. With a put option, you have the option of selling a stock at a specific price, on or before a certain date. You can use put options to bet on stocks falling in price, or as a way to hedge against falling stock prices in the event that the market turns lower. To sell put options (or on the flip side to buy call options), your trading account must offer options trading privileges.
You can also choose to trade inverse exchange-traded funds (ETFs).
For instance, if you buy an inverse ETF of the S&P 500 and the S&P 500 falls 1%, you make a 1% profit. You can also trade inverse ETFs with leverage, meaning you only put down a small amount of the total investment, and you can make a bigger profit than usual if you guess right. The problem is you’ll lose more than you would on an unleveraged trade if you guess wrong.
How to Know when a Bear Market is Over
It’s nearly impossible to spot the bottom of the market as it’s happening. Instead, watch for signs of market strength, such as big gains occurring with heavier than usual trading volume, as well as a strengthening economy, improving corporate earnings, and other market-positive events.
Congratulations, you now have a firm grasp of what happens in a bear market, and why. If you want to learn more about general market principles, check out some of the other articles on our site. If you’re ready for the next lesson, click the arrow at the bottom of this page and off you go!