Bear Markets

Many investors don’t fully understand what bear markets are or how to recognise them. This article discusses bear markets in detail, including how to identify them and some of their common characteristics.

What Characterises a Bear Market?

We define a bear market as a fundamentally driven equity downturn of 20% or more over an extended period of time. From World War II through 2019, the S&P 500 saw 11 bear markets showing an average decline of 34% and lasting, on average, 16 months.[i]

Bear markets are commonly remembered for the widespread uncertainty and fear they tend to cause for investors watching their account values decrease. This fear often leads investors to panic and deviate from their investment strategy, which may ultimately hurt their long-term returns if they miss the subsequent rebound.

Identifying a Bear Market

Bear markets tend to begin with an inconspicuous slowing of economic momentum at a time when most investors are experiencing a false sense of security or when market euphoria is at a high. As underlying fundamentals show weakness or warning signs, euphoric investors pay no heed to them, looking instead for reasons stocks should continue their rise. Less commonly, bears can also start when a big, unforeseen negative economic event suddenly sends the economy into a recession.

Generally bear markets are extremely difficult to identify early on, but with thorough analysis and practice, we believe a fundamental bear market can be identified and potentially even side-stepped, if recognised before some or all of the portfolio decline occurs. If you identify a bear market late and significant decline in portfolio value has already happened, we believe you are likely better off staying invested. As difficult as it may seem, doing so can prevent you from realising losses in your portfolio. Also, if you have a reasonably long investment time horizon, remaining invested is a good way to be sure you’ll be in the market to benefit when the next bull inevitably begins.

Four Bear Market Rules

We have four basic guidelines for bear markets. It’s important to keep in mind no two bear markets are the same, therefore no one metric is perfect for identifying every bear market.

• The Two-Percent Rule. At the start of a bear market, stock prices often decline about 2% per month. Contrary to popular belief, bear markets don’t often begin with sharp, sudden drops. If there is a steep drop of much more than 2% per month, what you’re experiencing may just be a short-term correction and not a bear market.
• The Three-Month Rule. One of the most dangerous things investors can do is risk calling a peak too soon and missing bull market returns. This rule recommends waiting three months after you believe the market has peaked before going defensive. This provides a window of time to assess fundamental data, market action and possible drivers for the bear.
• The Two-Thirds/One-Third Rule. Analyzing historical bear markets, we’ve observed about one-third of bear markets’ decline tends to occur during the first two-thirds of a bear market, and about two-thirds of the decline occurs during the bear’s final third. So it may not be as important to miss the initial drop, as the sharper drops often occur later on in the bear market.
• The 18-Month Rule. We have found that modern bear markets last an average of less than 18 months, and they rarely last two years or longer. Because of this, we don’t believe staying defensive for longer than 18 months is typically in your best interest. Waiting too long to reinvest in equities can mean missing out on a dramatic rebound as a new bull market begins.

Not a Rule: Recessions. Don’t confuse economic recessions and bear markets. While the two may coincide, bear markets can occur without a corresponding recession and vice versa. Importantly, because stocks typically lead the economy, you shouldn’t use a recession to identify a bear market—by then, the bear market has likely started already and may have already ended.

More Bear Market Indicators

Although no single indicator can accurately signal a bear in advance every time, we believe a combination of leading indicators coupled with research and analysis can help you identify a bear market in its early stages and potentially avoid some of the ensuing decline.

We believe fundamentals play a key role in determining the current state of the market. A few examples of negative fundamentals include:

• Weak corporate earnings
• Inverted yield curves (when short-term bond rates are higher than long-term bond rates)
• Faltering revenue growth

Just as important as fundamentals, history has shown that euphoric investor sentiment can be a lead up to a bear market. Indicators of euphoria may include:

• High leveraged-buyout activity
• Rising corporate debt
• Overpriced initial public offerings

When euphoric investors keep finding reasons why equities should keep rising whilst ignoring decelerating or negative fundamentals, a bear market could be on the horizon.

What Signs Suggest a Bear Market May Be Forming?

Every bull market climbs the proverbial “Wall of Worry”—short-term worries that cause short-term investor fear and volatility during a broader bull market. These ongoing fears can lead to stock market volatility and maybe even bull market corrections—sharp sentiment-based downturns of about -10% to -20%, which are often mistaken for bear markets. But these corrections typically lack the size and scale of a true bear market, and since they are often based on fear, trying to trade around corrections can be a futile exercise.

Sometimes a bull market runs into a “wallop,” an unexpected negative big enough to knock several trillion dollars off global GDP. Think of it as a big, bad, unexpected negative that “wallops” an otherwise strong economy and bull market.

However, while wallops have happened, they are rare. More often investors misunderstand an event’s impact and how it fits into the bigger picture. Overestimating the potential impact of any event could cause investors to falsely spot wallops or mistake bull-market corrections for bear markets.

That’s No Bear!

With so many factors to consider, it can be difficult to determine what will lead to the start of the next bear market and a standard bull market correction. Corrections are unpredictable swings—usually based on fear and often lacking the weak economic fundamental backdrop of a bear market. Consistently timing corrections is near impossible as they start with a bang and end just as quickly. Further, going defensive at the wrong time can potentially set you back from meeting your goals. We believe you’re often better off staying disciplined and riding through corrections and other bull market volatility.

Anticipate the Recovery

Finally, we debunk one of the most prevalent investing myths: One big bear and you’re done! Our research shows that even if you weathered every bear market without making one defensive move, your equity portfolio would still have grown to generate a cumulative profit over the longer term, as bull markets are generally longer and stronger than their preceding bear markets. Keep in mind that every bear market is followed by a bull market. If you wait too long to re-enter the equity market after a crash you may miss out on the next bull market’s initial bounce.

Don’t let one big bear market scare you out of equities for good. You may need their long-term growth in order to meet your longer-term investing goals.

If you’re worried about volatility or a bear market, we can help. We stand by our clients when markets are rising and when they are falling—even in challenging, frightening times. We can be your partner and keep you on track. Contact us directly to see how.