Understanding Bear Markets

What Bear Markets Are, How They Work, and Why You Need to Know

Bear Market Definition
A bear market is a phrase used to describe an industry, sector, stock market, or other market that has declined in value by 20% or more. Blend Images / John Lund / Getty Images

Last year, I wrote an article entitled Understanding a Bear Market meant to explain the technical definition of a bear market, what causes them, and how they influence investor behavior. The first sentence read, "If you've only begun investing in the past few years, you aren't aware of what a bear market is." Unfortunately, that isn't the case anymore. Multiple times in the years since, Wall Street has reeled, stumbled, picked up speed, fallen on its side, and gone in circles including a nearly catastrophic decline in 2008-2009 from the bursting of the housing bubble when equities saw 2/3rds of their quoted market value obliterated over a short period of time.

 Now, in 2016, markets around the world are once again apprehensive, the United Kingdom has officially entered a bear market, the United States seems to be at risk of one, and professional and average investors alike have no idea where the market is headed, but everyone seems to have an opinion.  It seems like a good moment to revisit the concept.

Bear Market Definition: What Is a Bear Market and What Causes It To Occur?

By definition, a bear market is when the stock market falls for a prolonged period of time, usually by twenty percent or more. A bear market is the opposite of a bull market. This sharp decline in stock prices can happen for any number of reasons such as investors panicking over economic news such as a decline in corporate profits, a correction of overvaluation from a previous bubble, a liquidity crisis caused by structural weaknesses (e.g., the near bankruptcy of AIG and Lehman Brothers during the credit crisis presenting a real risk of counterparty default setting off a daisy chain implosion throughout the financial sector), or nothing more than the short-term mercurial whims of mass psychology.

One of the best examples of a prolonged bear market the painful one that occurred in the 1970's when stocks went sideways for well over a decade after collapsing in the 1973-1974 levels to the point they reached valuations that made them more attractive than they had been in generations. Experiences such as these are generally what scare would-be investors away from investing; you never know when they are going to materialize and must have the psychological and financial fortitude to deal with them.

Ironically, this fear can sometimes keeps bear market alive.

How Does a Bear Market Influence My Investments?

Generally, a bear market will cause the securities you already own to drop in price, perhaps by a substantial degree.  The decline in their value may be sudden, or it may be prolonged over the course of time, but the end result is the same: The quoted value of your holdings is lower. This leads to two fundamental principles:

1.) A bear market is only bad if you plan on selling your stock or need your money immediately.

2.) Falling stock prices and depressed markets are the friend of the long-term, value investor.

In other words, if you invest with the intent to hold your investments for decades, a bear market is a great opportunity to buy. It always amazes me that the "experts" advocate selling after the market has fallen. The time to sell was before your stocks lost value. If they know everything about your money, why they didn't warn you the crash was coming in the first place?

In fact, bear markets actually accelerate investor returns over longer periods of time despite it seeming counterintuitive.  I explained some of the math, based upon research out of Wharton, in a personal blog entry I wrote on investing in shares of the oil majors.

 Essentially, on a diversified basket of equities, reinvested dividends act as a "return accelerator", to borrow a phrase.  These drag down the cost basis of the portfolio as a whole so the quoted market value needs to increase by a smaller degree to reach breakeven than the original cost of the investment.  An extreme example is the Great Depression.  If you look at stock prices as a whole, you might mistakingly believe it took 25 years for the stock market to return to its previous level.  For an actual individual investor who was able to hold his or her shares, plow the dividends back in through the maelstrom, and sit tight, breakeven occurred in a few short years.

What Do I Do With My Money In a Bear Market?

The first thing you need to do is to look for in a bear market is companies and funds that are going to be fine ten or twenty years down the road.

There aren't many of them.  When I originally penned this article roughly 15 years ago, I mentioned that, "If the stock market crashed tomorrow and caused Gillette's stock price to fall 30%, people are still going to buy razors. The basics of the business haven't changed."  Today, Gillette is part of Procter & Gamble but it still holds true.  There are a handful of truly excellent businesses - maybe 100 in the world out of the 30,000 publicly traded firms - that have the economic franchise valuebalance sheet, and income statement to survive all but the most catastrophic scenarios.  These includes enterprises such as Coca-Cola, Hershey, Colgate-Palmolive, Unilever, Nestle, Clorox, Johnson & Johnson, and ExxonMobil.  

This brings us to our third principle when dealing with bear markets:

3.) You must learn to separate the stock price from the underlying business. They have very little to do with each other over the short-term.

No matter how much certain academics want it to be true, the market is not perfectly efficient over periods of less than many years.  When you understand this, you will see falling stock markets like a clearance sale at your favorite furniture store; load up on it while you can because history has borne out that prices will eventually return to more reasonable levels provided the earnings materialize.

Secular Bear Markets Are Different

There is another concept related to the basic bear market known as a "secular bear market".  You can learn about it in this piece on secular bear markets as it is important bit of knowledge to add to your understanding of economics and finance.