Four Bear Market Rules

VIDEO: 4 Bear Market Rules

4:11 minutes

In this video you’ll learn the four rules Fisher Investments uses to identify bear markets. While more guidelines than “rules”, learn how they help investors understand the difference between a bear market and a correction.

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The ability to understand bear markets—defined as fundamentally driven market drops of approximately 20% or more, usually over an extended period of time—is an important factor to consider when investing in the stock market. But many investors may not fully understand what bear markets are or how to recognise them, which can lead to emotionally driven trading decisions that can jeopardise investors meeting their long-term financial goals. Fisher Investments believes close monitoring of fundamental market factors is essential to identifying an approaching bear market. These factors include political, economic and sentiment market drivers. In Fisher Investments’ view, technical indicators alone are not sufficient to identify an impending bear market. However, Fisher Investments’ research shows bear markets rarely begin with a “bang”—they typically begin with a “whimper”: A rolling top over a longer period that lulls investors into a false sense of security.

Four rules can help identify this characteristic rolling top:

1. The Two Percent Rule: A bear market typically declines by about 2% per month. (Exhibit 1) Sometimes it declines by more than 2%, sometimes it’s less—but overall and on average, bear markets don’t often begin with the sharp, sudden drop some anticipate. If a bear does drop by more than 2% per month, there’s often a market counter-rally that can provide better opportunities for investors to sell. (Or, it might just be a correction—for more, see the next section on corrections masquerading as bear markets.)

2. Three Month Rule: A long-running Forbes columnist named Joe Goodman advised investors in the 1940s and 1950s to never call a market peak too soon. This rule advocates waiting three months after you suspect a peak has happened before calling a bear market. Rather than trying to guess when a market top might come, this rule ensures one has passed before taking defensive investment action. It provides a window of time to assess fundamental investment data, market action and possible bear market drivers. (Exhibit 2)

Exhibits 1 and 2 show the characteristic rolling top of the S&P 500’s decline during the 1973-1974 bear market.

Source: FactSet, as of 24/07/2018. S&P 500 Price Index Level, indexed to 100 at 31/12/1972, from 31/12/1972 – 31/12/1974.Presented in US dollars. Currency fluctuations between the US dollar and pound may result in higher or lower investment returns. For S&P 500 Price Index performance over the previous 5 years, please reference Exhibit 5.

3. The Two-Thirds / One-Third Rule: Typically, about one-third of the market’s decline occurs in the first two-thirds of a bear’s duration, and about two-thirds of the decline occurs in the final one-third. (Exhibit 3)

4. 18-Month Rule: Whilst bull market durations vary considerably, since 1946 the average bear market duration is only 16 months. (Exhibit 4) Very few in modern history last fully two years or longer. If you’re engaging a defensive investment strategy, you probably shouldn’t bet on one lasting so long. The longer a bear market runs, the more likely you’re waiting too long to re-invest. If you remain bearish for longer than 18 months, you may miss out on the rocket-like market ride that is almost always the beginning of the next bull market run. Missing that can be very costly for investors.

Exhibit 3 source: FactSet, as of 24/07/2018. S&P 500 Price Index Level, indexed to 100 at 31/12/1972, from 31/12/1972 –31/12/1974.

Exhibit 4 source: FactSet, Global Financial Data, as of 19/03/2015. S&P 500 Price Index Level from 29/05/1946-09/03/2009. Returns are presented exclusive of dividends. For “Duration,” a month equals 30.5 days. Presented in US dollars. Currency fluctuations between the US dollar and pound may result in higher or lower investment returns. For S&P 500 Price Index performance over the previous 5 years, please reference Exhibit 5.

Beware a Correction in Bear’s Clothing

It’s also critical not to call a bear market falsely. If the market is just going through a correction (a short, sentiment-driven downturn of -10% to -20%), Fisher Investments believes you’re better off riding through it and maintaining your portfolio. It is impossible to accurately and consistently time market corrections because of the way they behave. A correction can start for any reason or no reason. Corrections lack the causes and features of the Wall and the Wallop. The Wall refers to the idea that as bull markets mature, various investor fears become accepted and dispelled. The Wallop refers to an unexpected, immovable object that is large enough to knock off several percentage points off global gross domestic product. Here are some potential signs you’re witnessing a correction:

• There is a recent or ongoing regional geopolitical conflict, act of terrorism or natural disaster receiving “doomsday” coverage by the media. These events can trigger stock market volatility.
• The economy is fundamentally strong otherwise.
• The stock market downturn has been sudden, short and sharp off a recent relative high, as opposed to a rolling top.

Choosing to undertake a bear market investment strategy and go defensive should be rare and shouldn’t be done by gut feel or by your neighbour’s opinion. Exiting the market is among the biggest investment risks you can take—if you’re wrong and you have a need for portfolio growth, missing bull market returns can be extremely costly. Importantly, there are no hard and fast market rules for an investor to blindly follow. Rather, staying informed about current market drivers and understanding the causes and indicators of bear markets are important parts of maintaining a disciplined portfolio management process aimed at achieving your longer-term investment goals.

Source: FactSet, as of 24/07/2018. S&P 500 Price Index Level, from 03/01/2011–02/01/2018. Presented in US dollars. Currency fluctuations between the US dollar and pound may result in higher or lower investment returns.