Many investors do not fully understand what bear markets are, or how to recognize one. In this article, bear markets are reviewed in detail, including how to identify them and some of their common characteristics.
So, what is a bear market?
A bear market is when the price of an asset falls over time. It is usually defined as when the price has fallen 20 percent or more from the asset’s 52-week highest price. In addition, it must have been at least two months since the highest listing. The opposite of the bear market is the bull market.
All kinds of assets can end up in a bear market. World stock exchanges, world index’s, commodities, individual prices, house prices and so on. Let us assume that the asset we are talking about here is the stock market. This is because it is often the stock market that you talk about when you talk about bear market.
It can be easy to confuse bear market with stock market crash and stock market correction. This is how it is often defined:
- Stock market crash: The stock market falls sharply for a day or two.
- Correction: The stock market falls 10 percent or more from its 52-week highest listing over the course of days, weeks or months.
- Bear market: The stock market falls 20 percent or more from its 52-week highest listing. It must have been at least two months since the peak.
A stock market crash can trigger a bear market, but does not have to do so by definition. In the same way, a correction can be made in a bear market, but the stock market can just as easily recover.
How to identify a bear market
Bear markets tend to start with the economy slowing down while most investors are lulled into false security or there is euphoria on the stock market.
When underlying fundamentals show weakness or warning signs, euphoric investors ignore it – they prefer to focus on reasons why the stock market will continue to rise.
In rare cases, bear markets can even begin when a large, unforeseen negative economic event suddenly throws the economy into a recession.
Bear markets are generally extremely difficult to identify initially, but I believe that – with careful analysis and experience – it is possible to identify a fundamental bear market and possibly avoid it, if it is identified before part or all of the portfolio decline has taken place.
If you identify a bear market at a later stage, and the portfolio has already lost significant value, we believe that the best thing is probably to continue investing.
It may seem difficult, but it can prevent one from realizing losses in the portfolio.
And if you have a relatively long investment time horizon, it can be smart to continue to be invested, so you can be sure to keep up with the upswing when the next bull market starts.
Four bear market rules
I have four basic rules for bear markets. It is important to keep in mind that no two bear markets are alike, so there is nothing that can be used to identify every single bear market perfectly.
1. The two percent rule.
At the beginning of a bear market, stock prices often fall by around two percent a month. Many people believe that bear markets often start with a sudden, powerful race.
But if there is a steep race with significantly more than two percent a month, it may be a short-term correction rather than a bear market.
2. The three-month rule
One of the biggest risks that investors can take is to hastily point out a stock market crash and miss out on bull market returns.
This rule recommends that you wait three months for what you think is the stock market peak before going on the defensive.
It provides a time to analyze basic economic data, market developments and potential drivers of a bear market.
3. The third rule
When I have analyzed historical bear markets, we have observed that around one third of the total decline of a bear market tends to occur during the first two thirds of the bear market, and two thirds of the decline comes during the last third.
So it does not have to be that important to avoid the downturn in the beginning, as the steeper downturns tend to come later during bear markets.
4. The eighteen month rule
I have found that bear markets in modern times on average last for under eighteen months, and they rarely last for two years or longer.
Therefore, I believe that it is often not in one’s best interest to be on the defensive for more than eighteen months. If you wait too long to start investing in shares again, you can miss a dramatic recovery when a new bull market starts.
Not a rule: recessions.
Do not confuse recessions with bear markets. They can occur at the same time, but bear markets can occur without a recession, and vice versa.
Also note that since equities are typically ahead of the economy, one should not use recessions to identify bear markets – when a recession comes, the bear market has probably already started and may even be over.
More signs of a bear market
Although there is no single indicator that can always be used to predict when a bear market will come, I believe that a combination of leading indicators together with research and analysis can help one identify a bear market in its early stages and possibly avoid some of the following declines.
I believe that fundamentals play a key role in determining the current status of the market. A couple of examples of negative fundamentals are:
- Weak corporate profits
- Inverted yield curves (when short bond yields are higher than long bond yields)
- Failing revenue growth
History has shown that not only fundamental but also euphoric investor sentiment can be the beginning of a bear market.
Signs of euphoria can include:
- Many loan-financed company acquisitions
- Rising corporate debt
- Stock market launches at a premium
As euphoric investors continue to find reasons why the stock market will continue to rise while ignoring weakened or declining fundamentals, a bear market may be underway.
What causes a bear market?
A bear market occurs when investors’ confidence in the stock market decreases, which causes them to sell their holdings.
When supply exceeds demand, the price of shares falls. This easily leads to a chain reaction as falling prices cause more and more people to step out of the market, which in turn causes prices to fall further.
When we talk about the bear market on the stock exchange, it is often closely linked to the economy. There can be many other reasons for a bear market but the economy weighs heavily.
As the business cycle begins to approach its end, the stock market swings downwards. When we then enter a recession, it is confirmed by the bear market.
When it looks darkest, the stock market turns upside down and eventually we emerge from the recession. Then there is usually already a bull market again. It’s a little simplified, it’s what it looks like.
How does the market “know” what will happen? It does not know: the market cannot predict the recession with certainty.
What happens is that the investor group constantly analyzes lots of parameters to assess when it is time to get off the boat.
It can be about looking at industrial production, growth, unemployment, inflation and more. Many investors who make the assessment that the economy has peaked are starting to sell off their holdings to avoid keeping up with the next bear market.
Ironically, this is exactly what triggers the bear market – given that enough investors have been pushing the sell button for a long enough time.
Sometimes there is a false alarm and then the correction may not have time to turn into a bear market.
More than just a question about the economy
Although bear markets often occur in connection with economic downturn, there may be other factors behind that trigger the bear market or that provide it with extra fuel.
One of these factors is a sharply overvalued stock market or stock market bubble. This was the case, for example, in connection with the IT crash.
Another reason could be an overly aggressive monetary policy. Here it is mainly the Fed in the US we get to look at, but also the ECB.
The interest rate is raised if inflation is high, so inflation can be an underlying factor. It takes us to commodity prices. If they shine, it leads to inflation, which has a negative effect on the economy.
Rising commodity prices can thus contribute to us having a bear market on the stock exchange.
Other factors that can be imagined are trade wars, wars, a debt bubble that bursts or a collapse in the housing market.
No matter how you turn and twist it, it is connected to the economy. If the economy is bad, for whatever reason, we can count on the bear crawling.
Things are connected and it is often not possible to point to a single cause (although many will make such simplifications to try to understand).
How long a bull market has been going on, however, does not matter when the next bear market occurs. A bull market can be longer than you think.
It should also be mentioned that world markets often influence each other. The stock exchanges in Sweden are greatly affected by the American stock exchanges and the DAX in Germany.
If, for example, the American stock exchanges enter the bear market, it is likely that our stock exchanges will do the same, but hardly the opposite.
That’s not a bear market!
With so many factors to consider, it can be difficult to determine what will lead to the start of the next bear market or a completely normal bull market correction.
Corrections are unpredictable fluctuations – usually based on fear, and often without the background of weak economic fundamentals that bear markets have.
It is almost impossible to time corrections correctly every time, because they start with a bang and end just as quickly.
If you go on the defensive at the wrong time, you can also risk delaying the journey to your goal.
I believe that it is often better to maintain discipline and wait for corrections and other volatility during bull markets.
Expect the recovery
Finally, we want to dispel one of the most stubborn investment myths: A big bear market and it’s run for you! My analyzes show that even if you had gone through every single bear market without taking a single defensive measure, your stock portfolio would still have grown to yield a cumulative profit in the long run, as bull markets are generally longer and stronger than previous bear markets.
Remember that every bear market is followed by a bull market. If you wait too long to return to the stock market after a crash, you risk missing the initial rebound in the next bull market.
Don’t let a big bear market scare you off the stock market forever. You may need the long-term growth that equities provide to reach your long-term investment goals.