How to Invest for a Bear Market

Smart Investor's Guide to Preparing for a Down Market

Bull and Bear Market
••• Getty Images/Jonathan Evans

What is the best way to invest during and prior to a bear market? There are certain types of stocks, bonds, and mutual funds that perform better when the market is in decline. You shouldn't wait for the announcements that the market is bearish; the best time to begin preparing for a market reversal is before it begins.

Learn more about bear markets and how you can take advantage of them.

Key Takeaways

  • A bear market is a market condition in which prices drop by 20% or more, or more than a market correction.
  • Not all market corrections will result in a bear market. But a bear market always follows a market correction.
  • Seasoned investors tend to survive bear markets by focusing on the stocks of companies that make products that are necessary for daily life.
  • The S&P 500 Index can give a general indication of a short-term market fluctuation, but it’s not foolproof.

What Is Bear Market?

A market correction is an occurrence where, as a whole, prices drop between 10% and 19%. A bear market happens when prices have fallen more than that of a market correction. That means they've fallen by 20% or more. There have been 22 market corrections but only four bear markets since 1974.

The length of time that the decline lasts is called the "duration." Historically, bear market durations have ranged from about three months to more than three years. Of the officially recognized bear markets, the durations were longer than one year but less than two years.

Is There a Bear on the Horizon?

There is no magical bell that rings when a bear market begins. In the past, bear markets have always been preceded by a market correction. But the problem is that not all corrections have led to bear markets. Since some corrections have led to bear markets, investors become nervous when the market corrects itself. They fear the bear and the losses that are brought by it.

This often results in people trying to time the market. This is not recommended. Bear markets tend to present themselves when market prices have been rising for a time; investors are feeling irrationally exuberant. This feeling is like a gambler's high during speculative bubbles. Speculators drive prices higher and higher.

What Investments Work in Bear Markets?

One method of investing during a bear market is to buy stocks at reduced prices. But you should be cautious with this approach. Stocks you buy in this market condition should be from entities that have weathered economic downturns before.

For this reason, many seasoned investors advise buying "toothpaste stocks." These are not necessarily stocks from companies that make only toothpaste. These are stocks in companies that produce a large number of items people will always need, such as toothpaste or other living necessities.

Note

Johnson & Johnson and Colgate-Palmolive are two companies that are considered toothpaste stocks.

If you have chosen your investment tools wisely, such as a 401(k) or index funds, you should continue contributing. The initial descent might bring the overall value of your 401(k) or fund down. But the purchases on the way down will be at a discount. When the market turns around again, you will come out on the other side with more value as prices rise in the bull market.

Bonds and precious metals could be your allies when a bear market emerges. These assets have often performed well in past bear markets, where stock prices and interest rates are going down.

Bear Markets and the Federal Reserve

No one is yet able to predict exactly when a bear market will begin. But there's a clue that might help you know when a bear market is closing in: when the Federal Reserve (the Fed) begins to raise interest rates again after lowering them.

When the Fed starts to raise rates, it means the economy is healthy and maturing. This most often occurs toward the end of a growth cycle. Meaning, this happens toward the end of a bull market, and closer to the bear market.

Note

Bear markets and recessions do not always occur hand in hand. But it can happen.

What does this mean? In most cases, investors would do well to stay fully invested when the Fed is decreasing interest rates or keeping them low. Corporations will borrow money at low rates; this often translates into more profit. That's because they invest the borrowed money in technology. Or, they may simply refinance debt from higher rates to lower rates. This generally occurs towards the peak of a bull market.

A bull market often peaks before the economy peaks. This is because the stock market is a forward-looking mechanism. It's also a "discounting mechanism" and a "leading economic indicator." In other words, the stock market will begin its bear market decline before it is announced that the economy is in recession.

In simple terms, stock prices today reflect investors' best guess as to near-future conditions. On the other hand, economists and the Fed look back at the recent past to guess current economic health.

Note

Stock market peaks and economic peaks occur at different times. This is because stocks are generally being traded before companies are gathering revenues.

How Can You Use the S&P 500 P/E Ratio as an Indicator?

An index is a benchmark for certain assets. The S&P 500 Index is a performance benchmark for the top 500 stocks (in the view of S&P) on the market. The price to earnings ratio (P/E) can be used as a gauge of valuation of the stocks listed on the index at any given time.

This is not a consistently accurate means of predicting short-term stock market fluctuations. But it can be used as a general barometer for figuring out if stocks may be over or undervalued.

If you learn how to interpret the overall value of stocks by using the P/E ratio on the S&P 500, you can gain insights into investor sentiment towards stocks. Therefore, you may be able to see the possible future direction of equity prices. When assets become overvalued, investors begin to panic sell to mitigate losses. This can cause a market correction, or lead to a bear market. Or, it might not cause anything but a small dip in prices.

Warning

Be cautious when trying to predict and base investing decisions on what the market will do. Many investors have lost everything trying to time the market.

The P/E ratio of the S&P 500 Index is not a simple ratio. One method is to look at each stock listed on the index and find the ratio on its page or calculate it. An internet search might provide someone else's results from calculating the P/E.

If you find your stocks have P/E ratios less than those you analyze from the S&P 500, you may want to reduce risk in your portfolio. You can do this by decreasing your exposure to stocks.

What Is Tactical Asset Allocation?

Asset allocation is the greatest influencing factor in total portfolio performance. This is especially true over long periods of time. An investor can be just average at investment selection but good at tactical asset allocation and have greater performance, compared to the technical and fundamental investors who may be good at investment selection but have poor timing with asset allocation.

Consider this example of tactical asset allocation: Assume you see some classic signs of a maturing bull market, such as high P/E ratios and rising interest rates. A new bear market appears to be on the horizon. You can then begin to reduce exposure to riskier stock funds and your overall stock allocation. You can also begin building your bond fund and money market fund positions.

Note

Having a portion of your portfolio you can switch back and forth for different market circumstances can help you continue to make gains.

Let's also assume your target (or "normal") allocation is 65% stock funds, 30% bond funds, and 5% cash/money market funds. Once you see P/E ratios at high levels, new records on major market indexes, and rising interest rates, you might take steps to reduce risk by reallocating to 50% stocks, 30% bonds, and 20% cash. All that remains is the actual mutual fund types that can help in reducing your overall portfolio's market risk.

Now consider that the average duration (length) of a bear market for stocks is one year. By the time economists herald the news that a recession has begun, the bear market may have already been in its downward spiral for three or four months. If the bear market decline is below average in duration, the worst may have already passed by that time.

Prepare For Different Markets

You may want to begin preparing your portfolio for bear and bull markets before they begin, rather than waiting until you know for certain a bear market has begun. You should work to build a strategy and portfolio structure before you begin to buy funds.

Create a diverse portfolio, tactically allocate your assets, be prepared to move small portions of capital around, and keep an eye on the market indicators. These methods can help you keep your portfolio earning when market reversals occur and can keep you from succumbing to the panic that other investors and speculators will feel when the bear stands up.