Investing in a Bear Market

When market volatility strikes, learn to tell the difference between a correction and a genuine bear market.

Bear markets are scary. They breed uncertainty and fear. However, with thorough analysis and practice, we believe a fundamental market crash can be identified and losses can mitigated. While no two bear markets are exactly the same, market indicators and historical perspective can help investors recognize a bear market early 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

Peak

Trough

Duration (Months)

Cumulative Returns

09/06/1929

06/01/1932

33

-86%

03/10/1937

04/28/1942

61

-60%

05/29/1946

06/13/1949

36

-30%

08/02/1956

10/22/1957

15

-22%

12/12/1961

06/26/1962

6

-28%

02/09/1966

10/07/1966

8

-22%

11/29/1968

05/26/1970

18

-36%

01/11/1973

10/03/1974

21

-48%

11/28/1980

08/12/1982

20

-27%

08/25/1987

12/04/1987

3

-34%

07/16/1990

10/11/1990

3

-20%

03/24/2000

10/09/2002

30

-49%

10/09/2007

03/09/2009

17

-57%

Bear Market Average

21

-40%

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:

Indicator

Description

Weak Corporate Earnings

Are market earnings degrading or falling for multiple successive quarters?

Inverted Yield Curve

Are overnight interest rates higher than long-term, 10-year bond rates?

Faltering Revenue Growth

Earnings can be affected by outside factors; sales, less so.

High Inventories, Low Demand

Are business inventories piling up, while consumers’ demand seems to be tailing off ?

Trend, Not Data Point

One data point isn’t sufficient evidence. The trend should recur for multiple readings and in multiple nations.


Euphoric
Investor Sentiment:

Indicator

Description

High LBO Activity

Are businesses taking on debt to buy competitors (leveraged buyouts)?

Overpriced IPOs

Are extremely low-quality IPOs flying off the shelves at sky-high valuations? Are companies going public solely for the sake of going public?

Rising Corporate Debt

Are businesses taking on more debt, despite slowing or negative sales and earnings?

Uniformly Bullish Media

Is the media uniformly positive—and are those who were already positive now euphoric?

“It’s Different This Time”

Is there widespread discussion of how “It’s different this time”?

Euphoria

Is everyone talking about stocks? Watching CNBC instead of the World Series or the Super Bowl? Are investors flooding into equity mutual funds? Is your taxi driver giving you stock tips?


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

Indicator

Description

Escalating Tariffs / Trade Wars

Are countries around the world constructing extreme barriers to trade?

Monetary Policy Errors

Has a major central bank made a severe policy error?

Regulatory Changes

Have there been massive changes in regulations or accounting rules that may adversely impact businesses?

Major Geopolitical Conflict

Is a major, global conflict likely to erupt?

Other Unknown Negative

Is there something else that can knock 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. 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 that 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. 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.

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

Bull Market Start

Bull Market End

First 3 Months' Return

First 12 Months' Return

06/01/1932

03/10/1937

92.3%

120.9%

04/28/1942

05/29/1946

13.5%

53.7%

06/13/1949

08/02/1956

16.2%

42.0%

10/22/1957

12/12/1961

5.7%

31.0%

06/26/1962

02/09/1966

7.3%

32.7%

10/07/1966

11/29/1968

12.3%

32.9%

05/26/1970

01/11/1973

17.2%

43.7%

10/03/1974

11/28/1980

13.5%

38.0%

08/12/1982

08/25/1987

36.2%

58.3%

12/04/1987

07/16/1990

19.4%

21.4%

10/11/1990

03/24/2000

6.7%

29.1%

10/09/2002

10/09/2007

19.4%

33.7%

03/09/2009

???

39.3%

68.6%

Average

23.0%

46.6%

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.