Bear Markets and How to Recognize Them

How to Tell If We Are in a Bear Market or a Bull Market

couple reviewing financials
•••

 Photo by Eric Audras / Getty Images

A bear market is when the price of an investment falls at least 20% or more from its 52-week high. For example, the Dow Jones Industrial Average hit its record high of 26,828.39 on October 3, 2018. If it fell 20% to 21,462.71, it would be in a bear market.

Bear markets can occur in any asset class. In stocks, a bear market is measured by the Dow, the S&P 500, and the NASDAQ. In bonds, a bear market could occur in U.S. Treasurys, municipal bonds, or corporate bonds. Bear markets also happen currencies, gold, and commodities such as oil. Price drops in consumer goods, such as computers, automobiles, or TVs, are not bear markets. Instead, that's called deflation.

Bear markets created the saying "It's not how much you make, it's how much you keep." A ferocious bear market can wipe out years of hard-won gains made in a bull market. It's important not to get too greedy, and to take profits on a regular basis. 

How to Recognize a Bear Market

A bear market occurs when the major indices continue to go lower over time. They will hit new lows. More important, their highs will be lower than before as well.

The average length of a bear market is 367 days. The conventional wisdom says it usually lasts 18 months. Between 1900 and 2008, bear markets occurred 32 times with an average duration of 367 days. They typically happened once every three years.

Bear markets are accompanied by recessions. That's when the economy stops growing and then contracts. That creates layoffs and high unemployment rates.

You can recognize a bear market if you know where the economy is in the business cycle. If it's just entering the expansion phase, then a bear market is unlikely. But if it's in an asset bubble or investors are behaving with irrational exuberance, then it's probably time for the contraction phase and a bear market. In 2018, we are in the expansion phase of the current business cycle.

Causes

A bear market is caused by a loss of investor confidence. loss of business and consumer confidence. As confidence recedes, so does demand. This is the tipping point in the business cycle. It's where the peak, accompanied by irrational exuberance, moves into contraction.

This loss of confidence can be triggered by a stock market crash. That occurs when stock prices plummet 10% in a day or two. Crashes are dangerous because prices only have to fall another 10% to enter the bear market.

Investors also worry about bear markets after a stock market correction. That's when prices decrease by 10%. A correction can take place over weeks or months.

Examples

The Great Depression bear market was the worst in U.S. history. The Dow fell 90% in less than four years. It peaked at 381.17 on September 3, 1929, and fell to 41.22 by July 8, 1932.

It was caused by the 1929 stock market crash. It followed an asset bubble caused by a financial invention called buying "on margin." It allowed people to borrow money from their broker, only putting down 10% to 20% of the stock value. When a scandal rocked the British stock market, investors lost confidence in the U.S. market, triggering the crash.

Stock prices fell 23% in four days. Investors lost $30 billion, the equivalent of $396 billion today. That terrified the public because it exceeded the cost of World War I.  The Dow didn't regain its September 3, 1929, high until November 23, 1954.

The second-worst percentage-wise was the 2008 bear market. It began on October 9, 2007, when the Dow closed at 14,164.43. It fell 53.4% to close at 6,544.44 on March 6, 2009. This was the second-worst decline in history. It was caused by the 2008 stock market crash, the failure of Lehman Brothers, and the reluctance of Congress to restore confidence by passing a bailout. It didn't end until the government launched the Economic Stimulus Plan of 2009. The Dow didn't regain its 2007 high until March 5, 2013, when it closed at 14,253.77.

The third-worst percentage-wise was the 1973 bear market. It began on January 11, 1973, when the Dow closed at 1,051.70. It fell 45% until it closed at 598.64 on December 4, 1974. President Nixon helped create this recession by ending the gold standard. That caused inflation as the dollar rose.

The 2000 bear market began on January 14, 2000, when the Dow closed at 11,722.98. It fell 37.8% until it hit its bottom of 7,286.87 on October 9, 2002. It triggered the 2001 recession. It was worsened by the 9/11 terrorist attacks which shut down the stock exchanges. It ended the greatest bull market in U.S. history. The Dow had risen 1,409% since its 776.82 close on August 12, 1982.

The 1970 bear market began on December 31, 1968, when the Dow closed at 908.92. It fell 30% until it bottomed out at 631.60 on May 26, 1970.

Bull Market Versus Bear Market

A bull market is the opposite of a bear market. It's when asset prices rise over time. "Bulls" are investors who buy assets because they believe the market will rise. "Bears" sell because they believe the market will drop over time. Whenever sentiment is "bullish," it's because there are more bulls than bears. When they overpower the bears, they create a new bull market.

These two opposing forces are always at play in any asset class. In fact, a bull market will tend to peak, and seem like it will never end, right before a bear market is about to begin.

Bear Market Rally

A bear market rally is when the stock market posts gains for days or even weeks. It can easily trick many investors into thinking the stock market trend has reversed, and a new bull market has begun. But nothing in nature or the stock market moves in a straight line. Even with a normal bear market, there will be days or months when the trend is upward. But until it moves up 20 percent or more, it is still in a bear market.

Secular Bear Market

Regular bear markets are called cyclical bear markets. A secular bear market lasts anywhere between five and 25 years. The average length is around 17 years. During that time, typical bull and bear market cycles can occur. But asset prices will return to the original level. There is often a lot of debate as to whether we are in a secular bull or bear market. For example, some investors believe we are currently in a bear market that began in 2000.

How to Invest

You can prepare for a stock bear market by decreasing risk in your portfolio. For example, you can increase the amount of cash and reduce the number of growth stocks. You can also select mutual funds that perform better in a bear market. These include gold funds, and sector funds focusing on health care and consumer staples.

During a bond bear market, individual bonds are safer than bond funds. Their interest rates and payments are fixed. If you hold onto the bond, you will receive the promised amount. In bond funds, you could lose money when the manager sells the bonds within the fund.

How the Bear Got Its Name

Why use a bear to describe an investment trend? In the late 1500s, people enjoyed bull and bear baiting. They gambled on which dogs could kill a bear chained to a post. Surprisingly, bear baiting still occurs in South Carolina, although it's illegal in the other 49 states.

That's how bears and bulls first became linked in people's minds. In the 17th century, hunters would sell a bearskin before catching a bear. In the stock market, short sellers did the same thing. They sold shares of stock before they owned them. They bought the shares the day they were to deliver them. If share prices dropped, they would make a profit. They only made money in a bear market.

The phrases were first published in the 18th-century book, "Every Man His Own Broker," by Thomas Mortimer. Two 19th century artists made the terms even more popular. Thomas Nast published cartoons about the slaughter of the bulls on Wall Street in Harper's Bazaar. In 1873, William Holbrook Beard painted the stock market crash using bulls and bears. (Sources: "Symbolism of the Bull and Bear," Federal Reserve Banks of New York. "Origin of Bulls and Bears," Motley Fool. "Bulls and Bears," Valentine Capital Asset Management.