A bear market occurs when there are declining prices in a market for a prolonged period of time. It often involves the price of securities falling by 20% or more. This generally happens amid widespread investor pessimism. It’s important to understand what exactly a bear market is. Especially when it comes to the impact this has on your investment choices and financial planning.
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Understanding Bear Markets
Bear markets are usually associated with declining prices in a market or index. For example, the S&P 500 market index. Individual securities and commodities are in a bear market if they experience price declines of 20% or more over a long period of time.
Bear markets arise during general declines in the economy. The Great Depression was the first and most famous bear market. Another widely-known example is the 2008 housing crisis.
They last anywhere from several weeks to many years and are either secular or cyclical.
A secular market is a bear phase that usually lasts between 10 and 20 years. This is when the market sees below-average returns for a prolonged time. Market prices will keep reverting back to lower levels until the bear phase is over.
On the other hand, a cyclical bear market is when bearish trends last for a short period of time. These tend to last anywhere from several weeks to a few months.
What Causes a Bear Market?
There are many things that lead to bearish phases in a market. In most cases, it comes down to a slowing or weak economy. Common signs of a slowing economy are high unemployment rates, low disposable income, and drops in business profits.
Government intervention in the economy is another contributor to bearish market trends. For example, changes to the tax rates may cause price movements that result in a bear market.
Another important factor behind bear markets is investor confidence. Financial markets and market sectors are greatly affected by investors’ choices.
Investors tend to opt for the safety of fixed-income or cash securities during a bear market. Rather than buying into the market, investors will want to sell their securities.
Phases of a Bear Market
There are typically four different phases that are tell-tail signs of a bear market.
- The first phase is when market prices are high and there is strong investor optimism. Near the end of this phase, investors will start to exit the market to take in the profits that they have made.
- During the second phase, stock prices will start to decrease sharply. This is because of a drop in trading activity. As a result, corporate profits will start to decrease. Many investors begin to panic when consumer optimism starts to fall.
- Third phase follows when speculators start to enter the market. This leads to a rise in some prices and a slight increase in trading volume.
- During the last phase of a bearish market, stock prices will continue to gradually drop. After a period of time, low prices and a rise in market optimism usually attract more investment activity. This leads to a gradual price increase which allows the market to exit the bearish trend.
How to Take Advantage
There is a signifcant amount of potential loss in a bear market. If you plan to invest in equities during this time then you should do so carefully. During a bear market, most investors move their money into cash or fixed-income securities.
Another way to prepare is by careful financial planning. Your financial advisor should help you avoid making any rash financial decisions. A big trap that investors fall into is making financial decisions based on emotion.
Some professional investors attempt to make profit during bear markets by short selling. This strategy involves selling borrowed shares and buying them back at lower prices. It is a risky trade and has high potential risk if it doesn't work out.
A short seller borrows shares from a broker before placing a short sell order. The profit is the difference between the sell price and the buy price of the shares.
For example, an investor shorts 500 shares of a stock at $100. The price falls and the shares are covered at $90. The investor pockets a profit of $10 x 500 = $5,000. If the stock unexpedetly trades higher, the investor must buy back the shares at a premium. This results in a heavy loss for the trader.
There are many examples of bear markets in recent decades around the globe.
In December 2018, major US market indexes were on the brink of a bear market. Several indexes fell almost 20% in value.
Before this, the famous housing crisis occurred in the United States between 2007 and 2009. The bear market during the financial crisis lasted for about 17 months. This caused the S&P 500 index to fall by 50% in value during this period.
More recently, major indexes such as Dow Jones Industrial Average saw a sharp decline in value. This brought the indexes into a bearish phase in March 2020.
During February 2020, stocks across the globe entered into a sudden bear market. This was a result of the COVID-19 global pandemic. The DJIA index dropped by 38% after its all-time record high during February.
Bear markets occur in conditions where market prices fall by more than 20%. This is often accompanied by declines in economic prospects and investor pessimism.
Understanding market direction goes a long way in planning your long-term investment strategy. This will help you manage your risk and achieve your financial goals.
Strong risk management and diversified portfolios are key to managing the ebbs and flows of the market.