Investing in a Bear Market

Bear markets are scary. They breed uncertainty and fear. However, while no two bear markets are exactly the same, market indicators and historical perspective can help investors recognize a bear market and invest accordingly.

Tip 1: Study stock market history for perspective

A bear market is a market drop of -20% or more over an extended period of time. Thirteen S&P 500 bear markets have occurred since 1929. Although they’ve varied in depth and duration, the average bear market saw the S&P 500 decline -40% over 21 months. Of course, some bear markets have been much shorter: The 1987 bear only lasted three months. On the other hand, the 1937 bear market (during the tail end of the Great Depression) lasted over five years.

S&P 500 Bear Markets, 1929-2009

Source: FactSet, Global Financial Data, as of 03/19/2015. S&P 500 Price Index Level from 09/06/1929 - 03/31/2015. Returns are presented exclusive of dividends. For “Duration,” a month equals 30.5 days.

Tip 2: Distinguish between normal volatility and bear markets

Just as it’s important to understand what a bear market is, it’s also important to know what a bear market isn’t. Investors often confuse corrections and bear markets. Corrections are sharp, short-duration market moves of -10% to -20% amid a larger bull market. They are typically based on psychological factors or false fears—not fundamentals—and tend to be fleeting. These market swings are common even in great bull market years, but many investors are still thrown off course by them. But it’s critical not to confuse a bear market and a correction. If the market is just going through a correction, we believe you’re better off riding through it. Corrections can start for any reason or no reason, and it’s impossible to accurately and consistently time them. This is because corrections lack the causes and features of a bear market.

Tip 3: Don’t confuse economic recessions and bear markets

Many folks also think a bear market is the same as an economic recession—which is typically defined as a decline in Gross Domestic Product (GDP) for two or more consecutive quarters. While a bear market can coincide with a recession, bear markets can also occur without a corresponding recession and vice versa. Recessions aren’t very useful for forecasting bear markets because the stock market typically leads the economy—in other words, stocks move first. Bear markets often start and end before recessions have run their course.

Economic Recessions and the S&P 500

Tip 4: Understand what causes a fundamental market crash

It’s easy to pinpoint a bear market in hindsight. Identifying a market crash in advance is much more difficult. The key is having the perspective to watch for and identify the right components and the discipline to prevent your emotions from getting in the way.

What are some signs you can look for to suggest a bear market might be forming? Our research shows there are two ways bear markets start:

• The Wall: A bull market climbs the “Wall of Worry,” then runs out of steam amid widespread investor euphoria. As a bull market matures, more and more fears are dispelled and newly confident investors tend to buy in. When all worries wane, investors think the market will rise forever—assuming “It’s different this time.” A great example of this is the start of the 2000 bear market. At that time, tech-crazed investors believed valuations of weak companies with no proven revenue deserved exorbitant valuations. Once investor sentiment reaches euphoria, reality can’t keep up with sky-high expectations and the bull market runs out of steam. Overall corporate and economic fundamentals weaken, but investors are caught up in euphoria and either dismiss weakness or don’t notice it at This is the traditional way bear markets begin.

• The Wallop: A negative surprise with the power to knock several trillion dollars off global GDP hits an ongoing bull market. It’s a big, bad, unexpected negative that “wallops” an otherwise strong economy and bull market. Be careful, though, or else you’ll think you see Wallops around every corner. In our view, a potential Wallop must be big enough to knock a few trillion dollars off global GDP in order to qualify. Let’s take the Global Financial Crisis of 2008-2009 as an example: That was a bear market caused, in our view, by an ongoing bull market hitting an immovable object that brought it to a premature end—namely mark-to-market accounting (FAS 157) combined with the government’s chaotic response to the financial crisis. We believe this combination turned what otherwise might have been a correction into a full-blown bear market. Global GDP fell by more than $3 trillion—over 5%.*

*Source: FactSet, as of 10/12/2015. World GDP from 12/31/2008 - 12/31/2009 per World Bank data.

Tip 5: Monitor bear market indicators

With painstaking research and thorough analysis, impending bear markets can be identified and some of the bear market decline can be avoided. Keep in mind, though, no one has consistently and correctly called every bear market in advance.

Following are some useful indicators that can reflect negative fundamentals, euphoric investor sentiment and potential big negatives. But remember: No one indicator alone is perfectly predictive of bear markets.

Negative Fundamentals:

Euphoric Investor Sentiment:

A Wallop—Big Enough to Shave Several Trillion Dollars off Global GDP:

Tip 6: Prepare a defensive portfolio strategy

So you think you’ve identified a bear market? First, don’t panic. It may be a natural reaction, but in investing, your emotions are your worst enemy. They can make you act irrationally and ultimately undermine your long-term investing efforts. Second, don’t make snap decisions. Always consider the possibility you’re wrong. An incorrect bear market call can be seriously detrimental to reaching your longer-term financial goals. Suppose you move your entire portfolio to cash in anticipation of a bear market and stocks suddenly surge +10%. You’ve just lost 10%—plus any transaction costs you’ve incurred! That’s opportunity cost. Be careful not to call a bear market too soon.

“Going defensive” means preparing your portfolio for a bear market environment—which often involves drastically reducing equity exposure. Exiting the market is among the biggest investment risks you can take on. And if you are wrong, you could not only lock in losses if markets have fallen, you could also miss the big market up days you may need to reach your long-term goals.

The goal of going defensive isn’t to be up big when stocks are down—that’s far too risky. Instead, you should strive to get cash- or bond-like returns in the low single digits. If the market is down double digits and you are up even a few percent, you have done fantastic. Even being down a few percent is very good if the market is down double digits. In constructing defensive portfolios, the aim is: minimal volatility, high liquidity, tax efficiency and capitalizing on sector-level trends.

That being said, the best way to position your portfolio for a bear market very much depends on the specific market environment. If you are late to identify a bear market and big drops have started, you’re likely better off staying invested and riding out the storm. That is not easy advice, but if you are a long-term investor, remember, stocks rise over the long-term, including bear markets—your portfolio can survive.

Tip 7: Anticipate the market recovery

Every bear market is followed by a bull market. Waiting too long to re-enter the market after a crash can be dangerous—you might miss out on the next bull market’s initial upward thrust. Perfect market timing requires luck, not skill. Re-entering just before the bottom versus just after the bottom probably won’t materially impact your longer-term returns.

A Big Early Bounce—First 3 and 12 Months of a New Bull Market

Source: Global Financial Data, FactSet, as of 03/19/2015. S&P 500 Price Index Level from 09/06/1929 - 03/31/2015.

Most bear markets have lasted about a year to 18 months. Very few in modern history have lasted fully two years or longer. If you’re making a defensive move, you probably shouldn’t bet on a market crash lasting so long. The 2000 and 2008 bear markets were exceptionally long and deep. Don’t let recent history bias you—few bear markets have lasted over 18 months. If you remain bearish for much longer than that, you may increase the likelihood you’ll miss out on the rocket-like ride that is almost always the beginning of the next bull run. Missing that can be very costly.