Key Takeaways
The stock market has developed a reputation as one of the greatest wealth-building vehicles on the planet. For the better part of a century, Wall Street has returned about 10% annually to investors. It is worth noting, however, that patience is required to realize or beat the average return. If for nothing else, stocks don’t always go up. Rapid declines in each of the major indices are regular occurrences. In fact, significant drops are frequent enough to have been given their own moniker: a bear market.
As its name suggests, a bear market is indicative of poor market sentiment and performance. That said, bear markets aren’t necessarily a bad thing for long-term investors. While nobody wants to see their portfolio drop significantly, lower prices on quality stocks may give investors the ability to dollar-cost average and build stronger positions over time. Therefore, instead of looking at a bear market like an obstacle, investors should view it as an opportunity; one that gives everyone the chance to start a position in the best stocks to buy.
What Is A Bear Market?
On the surface, a bear market is an indicator reserved for when markets are performing poorly. Investors will often refer to equity markets as a bear market when both sentiment and stocks are trending downwards relatively quickly. Beneath the surface, however, there’s a more official bear definition: A bear market traditionally occurs when the market drops at least 20% from previous highs over approximately two or more months.
In their most common form, bear markets are used to describe sizable drops on the broader stock market. However, Wall Street is made up of several indices, not the least of which are immune to bear markets of their own. Consequently, bear markets may also be used to refer to any stock index, or to any individual equity which drops at least 20% from previous highs.
For example, the tech-heavy NASDAQ Composite is down about 24.1% from its previous high in April, and even more since the end of last year. According to the bear definition, the NASDAQ Composite is in a bear market, which makes sense. As interest rates rise, the cost of borrowing capital increases and eats into the profits of largely unprofitable technology companies. Since most tech companies aren’t yet profitable, both inflation and interest rates hurt future prospects. As a result, tech stocks have declined for the better part of 2022 and are officially in a bear market.
Similar to the NASDAQ Composite, the S&P 500 is also in a bear market. Down about 21.8% year-to-date, the index which tracks 500 of the largest companies listed on U.S. exchanges barely meets the criteria, but is in a bear market nonetheless.
For some perspective, the Dow Jones Industrial Average is not in a bear market. Down a more modest 15.6% from its previous high at the beginning of the year, the Dow’s bluechip holdings are more insulated from downturns. Consisting of some of today’s most prolific companies, the Dow is more capable of weathering the impending storm of inflation and a possible recession. With that in mind, the Dow has yet to enter a bear market.
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What Causes A Bear Market?
There is no single market indicator responsible for creating a bear market. Instead, bear markets tend to form in the wake of poor investor sentiment. Consequently, bear markets are predominantly created by investors who do not have a lot of faith in the major market indices over the short term. Investors are inclined to sell equities into headwinds that are expected to slow the economy. When economic indicators suggest the economy will slow down shortly, stocks tend to trade down on poor earnings. As a result, traders tend to sell stocks heading into times of uncertainty.
Uncertain markets are a trader’s worst nightmare. When the market is uncertain of where it is headed, traders and investors tend to sell their holdings in fear of their portfolios dropping further. That said, what causes uncertainty can vary from an impending recession to a black swan event.
The current bear market is the result of both a black swan event and a slowing economy. The introduction of COVID-19, for example, forced the Federal Reserve to drop interest rates and spark housing activity. At the same time, the government flooded the economy with stimuli to help citizens navigate the pandemic. The unique convergence of more capital in the market and low interest rates, however, weakened the U.S. dollar. In order to combat inflation, the Fed had to increase interest rates and reduce the buying power of many.
The increase in rates simultaneously made it more expensive for businesses and individuals to borrow money. As a result, any unprofitable company who relied on debt to conduct business immediately became less profitable. The market preemptively saw earnings being reduced and sold off, causing the bear market we are in today. That is an oversimplification of where we are today, but it more or less explains how things transpired over the last few years.
Phases Of A Bear Market
While no bear market is exactly the same, they can almost all be broken down into four distinct phases:
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Phase 1: The first phase of a bear market usually marks the end of a bull market. In particular, positive investor sentiment is intact due to high equity prices that have usually enjoyed a lucrative run. However, valuations tend to run too high with the momentum generated in the bull market. Once valuations reach a tipping point, investors start to cash out, which initiates the selloff.
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Phase 2: Often referred to as the capitulation phase, this phase is usually characterized by the further loss of sentiment. At this time, most investors start to lose faith in the short-term prospects of their holdings and sell their shares. As the prices trends down, those with less conviction give into the downward pressure and try to cut their losses. The selling starts to snowball as economic indicators start to look worse and worse.
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Phase 3: The third phase is characterized by increasingly lower valuations. The longer bear markets last, the more attractive valuations start to look on many companies. At some point valuations get too attractive to ignore, and speculators start to enter the market. As more people buy and trading volume increases, the pace at which shares drop in value starts to decelerate.
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Phase 4: The final phase of a bear market is still characterized by declining stock prices. However, valuations have typically come in so much that many quality stocks are finally worth buying again. As lower prices start to intersect with better economic news, bear markets start to show signs of bull markets.
How Long Do Bear Markets Last?
The bear market definition may suggest how far the market needs to fall in order to be considered “bearish,” but it doesn’t state how long it has to last. In fact, there is no set amount of time a market needs to trend downwards for it to be considered a bearish market. Instead of trying to predict how long a bear market will last, the best thing investors can do is look at previous bearish trends from market to market.
The S&P 500 has dropped enough to be considered a bear market 11 times since 1950. On average, each bear market lasted about 388 days. Of course, that’s just an average, and it’s entirely possible for bear markets to last much longer or shorter. In the early 2000s, for example, the “dot-com” bubble resulted in a bear market that lasted about two and a half years (929 days). The shortest bear market in history, and the most recent, saw stocks drop for 33 days following the outbreak of COVID-19 until they rebounded into bull territory.
All things considered, there is no telling how long a bear market will last. The underlying economic indicators will play a large role in deterring the length of the downturn, but the Federal Reserve’s corrective measures will also impact the duration of the slide.
How To Invest During A Bear Market
The first trick of investing in a bearish downturn is understanding the dichotomy between bull and bear markets. If for nothing else, you can’t have one without the other. Bull markets are almost always the direct result of bear markets, and vice versa. Once investors understand this basic principles of how these two types of markets interact with each other, long-term investors should apply the following tactics:
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Diversify: Investors need to diversify their holdings in any type of market. Whether debating to invest in a bear market vs. bull market, the means to the end remains the same: diversification. Building a diversified portfolio limits risk to the downside, especially in a bear market. With a broad portfolio of diversified stocks, investors mitigate risk by insulating themselves from a single event, news story, or poor earnings report, reducing their holdings’ value.
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Dollar-Cost Average: Investors will almost never be able to time a bottom in any bear market. Nobody knows when trends will reverse, but there are usually signs when the bottom is getting closer. When valuations start to look like bargains, for example, investors may want to put a little money to work in quality companies—even as their market cap is diminishing. Otherwise known as dollar-cost averaging, buying shares of great companies as they drop in price can bring down a portfolio’s average cost per share. Dollar-cost averaging is a great strategy for high-conviction, long-term investments because it gives investors a chance to build a quality position at bargain prices. If the stock is truly a great long-term play, the lower price should be viewed as a bargain.
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Buy Defensive Stocks: When diversifying holdings in a bear market, investors should look to add defensive stocks. Depending on what caused the bear market, it is almost always possible to build defensive positions in stocks that tend to outperform the market in slower economic times. Healthcare stocks, for example, tend to perform better than other industries when the economy is expected to struggle. If for nothing else, healthcare is the last thing people will cut back on when money is tight. While growth won’t be as explosive, defensive positions can help investors maintain their capital when most other stocks are declining.
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Invest Money You Won’t Need For At Least 5 Years: Market volatility, especially in a bear market, makes it difficult to trade stocks for a profit. While some traders are great at buying and selling equities regularly, the shorter amount of time a stock is held, the riskier the trade is. Conversely, the longer an investor holds a stock, the more likely it is to grow its market cap. As a result, investors should only invest money in the market they won’t need for at least five years. In doing so, investors limit the need to pull money out of the market at a time when stocks are down, and gives the equities a chance to grow.
Bear Market Examples
While bear markets may be unwelcome to new investors, they are anything but uncommon. Since the beginning of the 20th century, about 122 years, a total of 33 bear markets have taken place. At that rate, investors have come to expect a bear market every 3.6 years on average. In that time, bear markets have occurred for all types of reasons, but today’s investors are most familiar with the last three downturns:
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2000-2002: The bear market that took place at the turn of the last century was directly correlated to the rapid growth of the internet. Otherwise known as the dot-com crash, the rapid adoption of the internet created a frenzy for so-called internet businesses to go public. An influx of cash poured into poor companies hoping to capitalize on “the next best thing,” hiking the valuations of many undeserving businesses. As valuations skyrocketed, many investors cashed out, leaving the rest of the market to hold the bag. The exodus out of internet stocks led to a 75% decline in the NASDAQ.
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2008-2009: In 2008, the U.S. entered into The Great Recession following a trend of subprime mortgage lending and the subsequent transfer of the loans into investable securities. The resulting crisis forced many homeowners into foreclosure and slowed the global economy. When all was said and done, the S&P 500 had dropped as much as 50% from its previous high.
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2020: Prior to 2022, the most recent bear market was brought about by the pandemic. Once COVID-19 was officially declared an emergency, the global economy shuttered. The slowdown in global markets caused the stock market to drop at its fastest rate ever.
Summary
Not a single investor appreciates the drop in asset value bear markets are responsible for. The bear definition suggests portfolios will drop at least 20% from their previous highs. However, it’s important to remember how the market works. Despite the poor sentiment associated with bear markets, they represent the greatest opportunity to buy stocks at attractive valuations. Those who are able to stomach short-term volatility will most likely come out on the other end of a bear market even stronger.
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