A Bear market is when stock prices fall sharply over a long period of time.
In this type of market, pessimistic investors sell large numbers of shares. Meanwhile, the number of buyers keeps shrinking, causing prices to drop further and further.
A common definition of a Bear market is when prices drop by at least 20% for a minimum of two months.
Often, you will hear the term applied to the market more generally, or an index like the Dow Jones Industrial Average. However, if a commodity or security falls by at least 20% for at least two months, then that can be a Bear market too.
It is difficult, some say impossible, to predict when a Bear market is coming. However, we do know that economic recession, high inflation, and high unemployment can all trigger a Bear market.
Bear markets are often much riskier for investors than other markets, as existing holdings might lose value and the paths to profit become more perilous.
The opposite of a Bear market is a Bull market, where prices are rising and economic conditions are good.
How a Bear market works
In every market there are pessimistic, Bearish investors as well as optimists, known as Bullish investors. In normal circumstances, most investors are Bullish as stock markets tend to rise over time.
However, Bullish investors can turn Bearish in poor circumstances.
Not only that, but other normally Bullish investors might see other investors start selling and follow suit – becoming Bearish as well. This can cause a kind of snowball effect, as more and more investors start selling too.
The most famous Bear market in history is the Great Depression, which started with a US stock market crash in 1929. Effects of the crash were still being felt at the start of the Second World War.
In a Bear market, investors often sell riskier holdings and put their money back into safer bets like big tech giants or ‘safe haven’ assets like gold and silver.
Another key characteristic of Bear markets is short selling, essentially a bet that prices will go down.
Short selling consists of borrowing stock, selling it, then buying it back to return to the lender. The goal is to buy the stock back for less than it was sold for and pocket the difference.
Since a short seller is only borrowing the share to short it, they have to buy it back and return that stock to the lender. There is theoretically no limit on how much the share price might rise, and so a sudden share price rise can prove disastrous for short sellers.
Despite the risks, making money in a Bear market most often involves short selling.
Types of Bear market
Just like in the fairy tale, there are three Bear markets: event-driven, cyclical, and structural. Each type refers to the factors that turn investors Bearish in the first place. Some of these are worse than others, since the causes can be harder to manage or have wider implications.
Event-driven Bear markets are a result of, as you can probably guess, major events. Pandemics are obvious Bear market triggers that can suddenly upset markets. Other well-known triggers are wars and oil price shocks, like the 2014 Bear oil market, which arose as a result of a production glut.
Covid-19 is the most recent example of an event-driven Bear market, though this was surprisingly short lived. Indeed, the Bear market for the S&P 500 index lasted only a month.
Cyclical Bear markets come from the ebbs and flows of economic cycles, usually taking place at the conclusion of a business cycle.
Interest rates often drive a cyclical Bear market. If central banks hike interest rates too far then businesses and consumers struggle to borrow money and make investments. This, in turn, leads consumers to cut their spending, hurting business profits and tanking investor sentiment.
Structural Bear markets, meanwhile, result from structural problems. These types of bear markets can often be the worst of the three since they are usually correcting a major underlying problem.
The 2008 financial crisis is perhaps the best known structural bear market, triggered by the bursting of the housing bubble.
One theory for how the Bear market is that it comes from bearskin sellers, where middlemen would sell the skins before receiving them. These middlemen, known as ‘bearskin jobbers’ or ‘bears’, speculated on the future prices for the skins – making a profit from the difference between the cost and selling price.
Advantages of Bear markets
It might not seem like there could be any advantages to Bear markets. But, in fact, a Bear market can be a gift for the savvy investor.
The main advantage is that it’s an opportunity to buy shares at low prices. Many will sell cheaply out of fear for further price falls, which makes for an excellent time to invest.
Investors taking the conservative strategy known as dollar-cost averaging can do particularly well.
This strategy involves making a fixed investment over a fixed period, regardless of share price. That way, if the share price falls, the investor ends up spending the same amount but getting more shares.
On the broader sense, Bear markets also put the brakes on a runaway Bull market. Ultimately, stock markets should reflect the real values of the companies listed on them.
Take the dotcom bubble of the late 1990s as an example. Speculation in internet-based companies reached a fever pitch, with investors lavishing “.com” startups with cash while the majority of these companies failed to deliver profits or sometimes any revenue at all.
When this kind of bubble pops, which the dotcom bubble did eventually, it is inevitable.
A world where this kind of speculation continues indefinitely is not possible, nor is it desirable.
Bear markets can be an opportunity to understand your own risk tolerance.
Knowing how much you as an individual are prepared to handle is an important part of investing.
After that, it will be much easier to adjust holdings – or even overall strategy – to an acceptable level. This has the added benefit of making future Bear markets a less frightening prospect.
One expression you might often hear is “Bulls & bears make money; pigs get slaughtered”. The saying is a warning that it’s fine to be bearish or bullish, but too much greed can lead to financial ruin.
Disadvantages of Bear markets
When it comes to Bear markets, the disadvantages might spring more easily to mind. Especially given that they can be catastrophic enough to get ominous names like the Great Depression.
It is highly likely that many stocks in your portfolio will drop in value during a Bear market. After all, a decline in prices is part of what defines a Bear market.
Not only that, but the fall can be very sudden. In the dot com bubble, online pet supply store Pets.com’s shares went from an $11 debut to a mere $0.19 by the time it revealed it had gone bankrupt.
Bear markets are likely to present a sudden and unexpected challenges. Investments that might have been going well in the Bull market but can quickly turn sour before it’s possible to exit.
Watching out for indicators that a bear might be coming, like a suspected bubble or a sharp interest rate hike, is important. But even then, surprises are inevitable.
The pandemic is a great example. Even with warning from some scientists that a pandemic might happen in the future, knowing that it would happen at that specific time with that specific virus was impossible.
Many people would like to think that they would keep their heads in Bear market and follow a clear strategy. However, if that was the case, stock market crashes might never happen at all.
Mistakes are more likely in the chaotic environments that trigger market downturns, and when those around us are all making the same errors too.
What’s the Value?
- Be aware: pay attention to warning signs such as low employment, interest rate hikes, and bubbles.
- Be prepared: have a plan for what you will do. Will you use the opportunity to invest at low prices? Will you make savvy use of short-selling? Will you seek shelter in safe havens and safer bet stocks? Will you combine these strategies?
- Don’t panic: when the next Bear market comes to down, don’t let it get the best of you.