Let’s look at the definition of a bear market, what causes a bear market, the difference between a bull market and a bear market rally, and other important concepts for investors to understand.
What is a Bear Market?
Typically, a bear market is defined as a 20% drop from recent highs. The most common application of the term is to refer to the performance of the S& P 500, which is widely regarded as a leading indicator of the overall stock market.
The term bear market, on the other hand, can refer to any stock index or individual stock that has fallen 20% or more from recent highs. For example, we could say that the Nasdaq Composite entered a bear market during the dot-com bubble burst in 1999 and 2000. For example, suppose a company reports poor earnings and its stock drops by 30%. We could say that the stock has entered bear market territory.
Although the terms bear market and stock market correction are frequently used interchangeably, they refer to two distinct magnitudes of negative performance. A stock market correction occurs when stocks fall by 10% or more from recent highs, and a correction can be upgraded to a bear market once the 20% threshold is reached.
Causes of a Bear Market
A bear market is typically caused by investor fear or uncertainty, but there are numerous other possibilities. While the most recent 2020 bear market was caused by the global COVID-19 pandemic, other historical causes have included widespread investor speculation, irresponsible lending, oil price movements, over-leveraged investing, and more.
Bear vs. Bull
A bull market is essentially the opposite of a bear market. Bull markets occur when there is a sustained rise in stock prices, and they are typically accompanied by elevated consumer confidence, low unemployment, and strong economic growth.
Generally speaking, a bull market is defined as a 20% rise from the lows reached in a bear market, but the definition isn’t as strict as that of a bear market. Investors typically mark the start of a bull market at the market bottom of a bear market. For example, the S&P 500 reached the lows of the financial crisis in March 2009, so that is considered the start of the bull market that lasted until early 2020.
To be precise, two things generally need to occur before a new bull market can be declared: a rise of 20% from recent bear market lows and new all-time highs in the benchmark indices.
Bear market rally
The distinction between a bull market rally and a bear market rally is critical. A bull market is a long-term upward trend in stock prices that typically results in new all-time highs.
A bear market rally, on the other hand, refers to a rise in stock prices following the onset of a bear market, but it is only a temporary rise before new lows. Consider how the 2007-2009 bear market unfolded to get a sense of this concept. After reaching new highs in 2007, the stock market crashed in 2008 as a result of the subprime lending crisis, which resulted in the failure of several major banks. The market began to rise after bailouts were announced in late 2008, but it eventually reversed course and reached new bear market lows in March 2009.
How to invest in a Bear Market?
Bear markets can certainly be scary times for investors, and nobody enjoys watching the value of their portfolios go down. On the other hand, these can be opportunities to put money to work for the long run while stocks are trading at a discount.
With that in mind, here are some rules you can use for investing in a bear market the right way:
- Think long term: One of the worst things you can do in a bear market is make knee-jerk reactions to market movements. The average investor significantly underperforms the overall stock market over the long run, and the primary reason is moving in and out of stock positions too quickly. When stocks plunge and seem as if they’ll keep falling forever, it’s our instinct to sell “before things get any worse.” Then, when bull markets happen and stocks keep reaching new highs, we put our money in for fear of missing out on gains. It’s common knowledge that the main goal of investing is to buy low and sell high, but by reacting emotionally to market swings, you’re literally doing the opposite. Invest in stocks that you want to own for the long run, and don’t sell them simply because their prices went down in a bear market.
- Focus on quality: When bear markets hit, it’s true that companies often go out of business. One of my all-time favorite Warren Buffett quotes is, “When the tide goes out, that’s when we find out who has been swimming naked.” In other words, when the economy goes bad, companies that are overleveraged or don’t have any real competitive advantages tend to get hit the hardest, while high-quality companies tend to outperform. During uncertain times, it’s important to focus on companies with rock-solid balance sheets and clear, durable competitive advantages.
- Don’t try to catch the bottom: Trying to time the market is generally a losing battle. One thing to keep in mind during bear markets is that you aren’t going to invest at the bottom. Buy stocks because you want to own the business for the long term, even if the share price goes down a little more after you buy.
- Build positions over time: This goes hand in hand with the previous tip. Instead of trying to time the bottom and throwing all your money in at once, a better strategy during a bear market is to build your stock positions gradually over time, even if you think prices are as low as they’re going to get. This way, if you’re wrong and the stock continues to fall, you’ll be able to take advantage of the new lower prices instead of sitting on the sidelines.
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