When a market sees sustained price declines, it is called a bear market. It usually refers to a state in which there is widespread pessimism and unfavorable investor sentiment, causing securities prices to drop by 20% or more from recent highs.
Although declines in a market or index as a whole, such as the S&P 500, are frequently linked to bear markets, individual securities or commodities can also be classified as being in a bear market if they see a 20% or greater decline over an extended period of time, usually two months or longer. Bear markets can also occur alongside more general economic downturns, like recessions. Bull markets that are trending upward can be compared to bear markets.
Understanding Bear Markets
Stock prices typically mirror the anticipated future cash flows and profits of companies. When growth expectations diminish and predictions fall short, stock prices can experience a decline. Herd mentality, fear, and a rush to minimize potential losses can result in prolonged periods of reduced asset values.
One definition designates a market as bearish when, on average, stocks fall at least 20% from their peak. However, the 20% threshold is somewhat arbitrary, much like the 10% decline used as a benchmark for a correction. Another characterization of a bear market occurs when investors become more risk-averse than risk-seeking. Such a bear market can persist for months or even years as investors opt for safer, less speculative investments.
The causes of a bear market vary, encompassing factors such as a weak or decelerating economy, the bursting of market bubbles, pandemics, wars, geopolitical crises, and significant shifts in the economic landscape, such as a transition to an online economy.
Indicators of a weak or slowing economy typically include low employment, diminished disposable income, weakened productivity, and declining business profits. Government interventions in the economy, such as changes in tax rates or the federal funds rate, can also trigger a bear market. A drop in investor confidence may lead to the selling off of shares in anticipation of impending losses.
Bear markets can endure for extended periods, ranging from several weeks to multiple years. A secular bear market, lasting 10 to 20 years, is marked by consistently below-average returns. Although there may be intermittent rallies within secular bear markets, the gains are typically short-lived, and prices revert to lower levels. Conversely, a cyclical bear market may last from a few weeks to several months.
Close to the brink of bear market territory on December 24, 2018, major U.S. market indexes experienced a near 20% drawdown. More recently, between March 11 and March 12, 2020, major indexes, including the S&P 500 and Dow Jones Industrial Average (DJIA), sharply entered bear market territory.
The last prolonged bear market in the United States unfolded between 2007 and 2009 during the Financial Crisis, spanning roughly 17 months. The S&P 500 lost 50% of its value during that period.
In February 2020, global stocks abruptly entered a bear market due to the global coronavirus pandemic, causing the DJIA to plummet 38% from its all-time high on February 12 (29,568.77) to a low on March 23 (18,213.65) in just over one month. However, both the S&P 500 and the Nasdaq 100 reached new highs by August 2020.
Phases of a Bear Market
Bear markets usually have four different phases.
The initial stage is marked by elevated prices and positive investor sentiment. Toward the conclusion of this phase, investors gradually exit the markets to capitalize on profits.
In the subsequent phase, stock prices experience a significant decline, accompanied by a reduction in trading activity and corporate profits. Economic indicators, once positive, begin to dip below average. Investor panic ensues, a phenomenon known as capitulation.
The third phase witnesses the entry of speculators into the market, contributing to increased prices and trading volume.
In the fourth and final phase, stock prices continue to decline, albeit at a slower pace. Low prices, coupled with positive news, attract investors once again, initiating a transition from bear markets to bull markets.
Short Selling in Bear Markets
Investors have the potential to generate profits in a bear market through short selling, a strategy involving the sale of borrowed shares with the intention of repurchasing them at lower prices.
While this technique can be lucrative, it is inherently risky and may result in substantial losses if not executed successfully. Prior to initiating a short sell order, the investor must borrow the shares from a broker.
The profit or loss for the short seller is determined by the variance between the selling price and the subsequent repurchase price, known as "covered."
For instance, consider an investor shorting 100 shares of a stock at $94. As the price declines, the shares are covered at $84, resulting in a profit of $10 per share, totaling $1,000. However, if the stock unexpectedly rises, the investor may be compelled to repurchase the shares at a higher cost, leading to significant financial setbacks.
Puts and Inverse ETFs in Bear Markets
A put option grants its holder the right, without the obligation, to sell a stock at a predetermined price on or before a specified date.
This financial instrument serves as a tool for speculating on declining stock values and hedging against potential decreases to safeguard portfolios with long-only positions. Traders need to have options privileges in their accounts to engage in such transactions.
In comparison to short selling, buying puts is generally considered safer outside of a bear market.
Inverse ETFs are crafted to move in the opposite direction of the index they are designed to track. For instance, an inverse ETF linked to the S&P 500 would gain 1% if the S&P 500 index declines by 1%.
Leveraged inverse ETFs, which exist in two and three times magnification, amplify the index returns. Similar to options, inverse ETFs offer opportunities for speculation or portfolio protection.
Disclaimer
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RISK WARNING IN TRADING
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