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Bear Market Explanation and Investing Strategies

There is a cliché that “stocks only go up.” Well, in a bull market, that might be true. However, in a bear market, over 75% of stocks go down with the major indices. Bear markets are common, and nothing to be feared if your investment strategy is sound. In this post, we’ll do a deep dive into what a bear market is and how to profit from one.

What Is A Bear in the Stock Market?


A bear in the stock market is someone betting that the market is going down. Generally, they have a pessimistic view of the market and will likely short the market when their view aligns with proper technical analysis.

Unlike Bulls, Bears want stock prices to go down. However, Bulls tend to have the broader majority of say in the market, given that the market has increased on average over the past 100+ years.

Granted, there are downturns in the market, and these are the times when bears like to gloat. You can be a bear in any market, whether it is equities, commodities, crypto, etc.

What Is A Bear Market?


The generally accepted definition of a bear market is a correction from the most recent highs of a major index, like the S&P 500, of more than 20%. Granted, market corrections of this magnitude occur quite frequently. So it isn’t always cut and dry as to whether we are “in a bear market” at 20% off the highs, or not.

2022 Nasdaq QQQ 22% Price Decline
2022 Nasdaq QQQ 22% Price Decline

As an example, you can see the chart of the QQQ, the Nasdaq ETF, on Apr 21, 2022 shows that the market extended 22% into a correction, but then rallied back above that level. For this reason, we wouldn’t consider the chart above to be a “bear market,” yet.

One of the best ways to examine whether or not the market is a bear market is to look at individual, leading stocks. During a bull market, there will be market leaders which take the crux of the weight of the stock market and carry it higher. Usually, these are big-name growth stocks like Apple, Google, Amazon, Netflix, Tesla, and others. The majority of stocks will follow suit.

As the market begins to “roll over,” as analysts like to say, it is important to discern the character of individual growth stocks. Many times these stocks, as the former leaders, can tell you whether the stock market is strong or weak. In a sense, individual stocks can be in a “bear market” long before the stock market as a whole enters into a bonafide bear market.

Why Is It Called a Bear Market?


The reason a bear market is called a bear market is because of the moniker of bears and bulls. Investors who are pessimistic about the market are considered bears. Investors who are optimistic about the market are called bulls.

For this reason, when then the market goes down for a considerable amount of time, we call it a bear market. Bears get time in the spotlight for being right about their pessimistic outlook.

What Does a Bear Market Mean for Stocks?


Generally speaking, a bear market means that stocks are going down. In fact, 3 out of 4 stocks will follow the trend of the broader market, whether up or down. That’s according to Investor’s Business Daily. So, if you can imagine the NASDAQ, the S&P 500, the Dow Jones Industrial Average, and the Russell 2000 all going down more than 20%, guess what most stocks will be doing?

That being said, there may be a few outliers here or there, but as the great William O’Neil points out in his seminal book on making money in stocks, breakouts are very sparse and short-lived during bear markets. For that reason, you want to take a cautious approach to making new investments.

A bear market doesn’t mean that you can’t make money. Quite the contrary, actually. There have been traders and investors throughout history who’ve made a killing during bear markets. The most famous bear market trader is Jesse Livermore. He is famous for shorting the market in the Panic of 1905 and the crash of 1929, making a handsome sum of money.

What Is the Difference Between a Bull Market and a Bear Market?


The difference between a bull market and a bear market is the general trend of most stocks, including the indices like the S&P 500, Dow, or Nasdaq. But that’s not all. You can have a bull market or a bear market in cryptos, metals like gold and silver, and other commodities. In other words, a bull market is an upward trending market, and a bear market is a downward trending market.

Bull Market vs Bear Market

In a bull market, breakouts to new highs typically create opportunities to buy stocks and hold them for longer periods of time. Usually, this is an easy money-making environment. Whereas in a bear market, you’re better off sitting in cash or looking for shorting opportunities. It is much harder to make money in a bear market unless you are skilled at trading volatility.

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What Defines A Bear Market?


Technically speaking, a 20% decline from a recent price peak for an extended period of time is what defines a bear market in the major indices. However, a bear market is generally thought of as a distribution phase of the market.

If you are unfamiliar with the four stages or phases of a market price cycle, we should take a look at it. After all, it will help you distinguish between a bull market and a bear market.

Stages of the market cycle


A bear market is defined by the stage 4 markdown in the diagram above. Just like any product cycle in a retail market, the product is acquired at a wholesale price. After the product is marked up and sold, retailers mark the price down and look to accumulate once again at lower prices. The stock market is no different.

What Causes A Bear Market?


A bear market is caused by any number of factors, which combined lead to a decline in price valuations of stocks and indices. Some of these factors will include the following:

  • Extreme Price Valuations in Growth Stocks
  • Unrealistic Price to Earnings Ratios
  • Federal Reserve Monetary Policy Tightening
  • A Strong Dollar
  • Cyclical Profit Taking
  • Unforeseen Events


Let’s take a look at each one of these and discuss how they might cause a bear market.

Extreme Price Valuations in Growth Stocks


The market is a tool for generating growth and innovation. Many, if not most companies that are listed on the stock market are valued at many multiples above what the companies actually produce in earnings. In other words, the shares of most companies is worth more than the underlying assets or profits they make.

Why is this?

Well, speculation by investors, hedge funds, banks, and other market participants encourages growth in these companies well beyond their “book value.” It is a cycle that repeats itself year after year, decade after decade. It’s just like the price cycle shared above.

However, once the valuations of companies reach a fever pitch, or irrational exuberance, it is time for the investors or shareholders to take their profits and liquidate them in order to look for other opportunities at a better price and value.

This is exactly what happened in the dot com bubble of 2000. Internet start-ups were massively over-valued and eventually reached a peak. The market corrected drastically in the few years to follow. Have a look:

2000-2002 Bear Market S&P500

After a huge bull run, the SPY corrected over 50% from around $155 to $75. Many of the stocks that ran 2x, 3x, 4x, or more in that market never recovered.

Unrealistic Price to Earnings Ratios


The Price to Earnings Ratio (P/E Ratio) is a measure of a stock's price compared to its earnings per share. It is a tool that analysts use to consider whether a company is under or overvalued.

In a bull market, high P/E ratios typically abound. It is not uncommon to see growth stocks with P/E ratios of 100x. For example, at the time of writing this, TSLA stock P/E ratio is 136. In 2020, its P/E ratio was a whopping 1127! What this means is that Tesla’s stock price was trading 1127 times its EPS value which was $0.63 at the time.

Why is this important?

During a bull market these massive overvaluations are common as market participants speculate on the growth of promising companies with unique products and services. However, in bear markets, money typically flows into old guard staples like metals, consumer discretionary, and other asset classes with lower P/E ratios.

As a rule of thumb, the companies with the highest P/E ratios in bull markets have the farthest to fall in a bear market.

Federal Reserve Monetary Policy Tightening


The Federal Reserve is a private bank whose intention is to ensure that the economy is running efficiently through its monetary policies and actions. Depending on its lending rates or quantitative easing, it can affect how the stock market moves.

For example, US News and World Report explains how the fed provided relief during the pandemic of 2020:
“At the height of the coronavirus pandemic, the Fed positioned monetary policy to boost economic activity by reducing interest rates, buying up bonds, and getting cash in the hands of consumers to generate spending. This allowed for faster economic growth to help the economy move toward recovery.”

During these “easy money” environments, speculators and investors take advantage of extremely low interest rates by buying speculative assets in the markets.


However, once the Fed changes its tune by raising interest rates and tightening their loose spending habits, this could signal a risk-off environment in the market, forcing stock valuations down and causing investors to hedge their investments or seek other assets like real estate, gold, or other hedges.

A Strong Dollar


If you look at a comparison chart of the dollar vs the S&P 500, you’ll typically see an inverse correlation. Generally speaking, a weak dollar bodes well for stocks. After all, why would you be holding cash if the value of the dollar is falling? Take a look at this US Dollar ETF trending upward:
US Dollar Index


Now have a look at the S&P 500 ETF for the same time period:

SPY Chart 2022

Notice the difference?

Consider also that commodities like crops or metals will benefit from a falling dollar from foreign markets. Why? According to Zacks, “When the dollar is weaker, those same goods cost more, as the price is set according to the home currency of the company making the product.”

As could clearly be seen during the pandemic of 2020 and 2021, the health of the economy is not always correlated with the health of the stock market. As the dollar was falling during this time, employment numbers also fell, yet the stock market launched to all-time highs.

Cyclical Profit Taking


Investopedia describes a cyclical industry as “a type of industry that is sensitive to the business cycle, such that revenues generally are higher in periods of economic prosperity and expansion and lower in periods of economic downturn and contraction.”

For these industries, you may experience layoffs or expense reductions in certain times. This is often tied to a business cycle that looks very similar to the price cycle we displayed earlier. Once an “expanded” economy has reached its peak, the contraction phase begins.

Thus, as an investor, you would expect not only income to fall during the containment period, but also unemployment, stock prices, and general recessionary declines.

Unforeseen Events and Black Swans

Catastrophic events and unforeseen black swans can also take a toll on markets and lead to bear markets. Some of the most recent examples we have seen were the market crash of 2008 and the covid crash of 2020. One was caused by a financial housing crisis, the other by a virus.

Covid Crash Chart

If you study history, you’ll see that many market cycles are usually marked by very important events. These can be wars, rumors of war, health crises, financial disasters, or government leadership issues.

Regardless of what arises, it’s always prudent to stay abreast of current events and the potential toll they could bring to markets.

When Does a Bear Market Start?


A bear market “technically” begins when a correction in the market persists beyond a 20% downturn from the previous high. However, a bear market can start long before the indices turn.

Think about the indices as a cruise ship. Perhaps, the Titanic. Not only does the Titantic have a hard time turning on a dime, but it also takes it a while to fully sink. All the while, rescue ships are being lowered and the ship's patrons are abandoning it.

A bear market starts like this. Leading stocks are usually the first to abandon the upward progress of the market. As they start to roll over, the indices pause. However, as it becomes clearer and clearer that money is leaving these stocks, eventually everyone starts abandoning the ship.

Eventually, the market as a whole begins to sink. So, to answer the question of “when does a bear market start?”, it’s really dependent on context. You could have a swift correction on news of a pandemic, or you can have a slow steady demise as investors flee to other assets.

know your history to secure your future | Tradingsim

How Long Does a Bear Market Last?


Generally speaking, a bear market lasts much shorter than a bull market. According to TheStreet.com, we’ve had 12 bear markets since 1932 in the S&P500. In that same period, the market has produced 14 bull markets.

The average bear market lasts about 25 months. Whereas, the typical bull market lasts nearly 5 years.

This data suggests that bear markets are much shorter-lived than bull markets. Market contraction – bear markets – are a normal part of the fluctuation of the market over time. It is usually just a matter of holding out for lower prices and the process of accumulation to begin again.

How To Invest In a Bear Market: 5 Proven Strategies

You can make money in a bear market, believe it or not. Some investors make a handsome amount of money in this environment. To that end, let’s take a look at 5 proven strategies for investing in bear markets.

1. Short the Market Indices or Market Leaders

Astute traders may understand market cycles better than others and decide to short the market once it begins to stall. Stocks may go up in a bull market, but there is an old adage that “supply always wins.” Taking short positions or buying puts at the highs can be a great way to profit off the downturn.

After all, the point of creating a market of stocks is to sell shares and raise money for corporate operations, research, or expansion, right? So eventually supply will overtake demand and the market will correct.

In order to play this correctly, you need an understanding of distribution events. We discuss a few great strategies for recognizing distribution in our tutorials on double tops and head & shoulders patterns. Be sure to check those out.

As markets begin to roll over, you can take short positions in the leaders as they make weak rallies into overhead resistance. Gil Morales teaches this strategy really well and we discuss it in our SimCast interview with him.

2. Buy Inverse ETFs


If you don’t feel comfortable shorting the market or buying puts, you can go long certain derivatives like the SQQQ or the UVXY. These ETFs allow you to take advantage of short-term pullbacks by simply going long.

For example, if the QQQ, which is the ETF for the NASDAQ, is falling apart, you can take a long position in the SQQQ in order to profit from it. Here is the QQQ and the SQQQ during the same period:


QQQ chart

SQQQ Chart

As long as you time the demise of the QQQ in tandem with the rise of the SQQQ, you can have a profitable strategy.

3. Invest in Safe-haven Assets Like Gold or Real Estate


A true bear market will likely cause a liquidation of any asset class. So, while gold and silver or real estate may not be immune to market downturns, they might simply hold more value in the long run. This, of course, may depend in part on inflation as well.

Metals and tangible assets like real estate are often seen as a hedge against more speculative assets like stocks. The goal of this strategy is to simply park your money in something that will retain value and hope that the returns aren’t as bad.

4. Raise Cash


As we discussed earlier, the dollar usually does much better when stocks are going down. This is likely due to the fact that investors are liquidating their equity investments which are going down in value. As they raise cash, the value of the dollar goes up.

This can be tricky in times of inflation, however. If the dollar is losing value through inflation, it may be a “less-risky” option than stocks, but ultimately lose value the longer you hold. For this reason, it might be wise to continue investing in commodities that are holding up well during a bear market.

5. Dollar-cost Averaging

Dollar-cost averaging is just a fancy way of saying “averaging down.” While we don’t really recommend this as a trading strategy, per se, if you are a longer-term investor it might make more sense.

As we mentioned above, in the last 100 years or so, the market has always rallied to new highs and beyond after entering a correction. Dollar-cost averaging hinges on the belief that over time, the market will continue higher. For that reason, it makes sense to add to your long-term retirement portfolio during bear markets.

This allows you to take advantage of lower prices as you add to your investments. For the long haul, you want to add into the dips and allow the market enough time to correct and then resume its uptrend.

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How To Trade In a Bear Market

Bear markets are usually marked by increased volatility. As such, you’ll want to be highly alert, and highly experienced before attempting to trade in a bear market. That being said, there are strategies that can help you to trade in a bear market.

One strategy we recommend is to use your moving averages as guides for relief rallies and potential short entries. If you can identify weakness in certain stocks, wait for them to retest key moving averages like the 20ma, the 50ma, or the 200ma. If they hit a wall at these key areas, you can use them as tight selling guides for your short entries.

Here is an example of what this might look like using MU’s daily chart:

Shorting strategies in a bear market

You’ll notice that each time the stock popped back to its key moving averages, it resumed the downward trend.

You can also use breakdowns as opportunities to trade a bear market. Whether it is a key area like a head and shoulders neckline or just a key daily support level, once it breaks, it could lead to further downside price movement. Using MU as an example again, here are a few breakdowns in recent price action:

Selling bear market breakdowns

Just be sure that you are nimble and still managing risk when you are actively trading in a bear market. You never know when you’re going to get a “rip-your-face-off” rally that could throw your average entry price way off. Keep your risk management intact at all times.

What Is A Bear Market In Crypto?

A bear market in crypto is really no different from a bear market in stocks. It is simply a prolonged period of price declines. Because cryptos are a volatile market, similar to forex, you can experience a crypto bear market for many months or years.

For example, in this chart of Bitcoin futures on the TradingSim platform dating back to 2018, we can see a massive drop from the highs. BTC dropped nearly 90% that year:

Crypto Bear Market

In addition that year, mid-2019 to 2020 created a tough time for the crypto market as well. While it did eventually rally to new highs in 2020 and beyond, it is clear that even crypto can experience massive bear markets.

For that reason, if you are not a long-term investor willing to hold out these huge corrections, you should consider what you’ll do if this occurs again.

Bear Market Parting Thoughts

We hope this explanation of bear markets and how to invest in them has served you well. Like any strategy in the market, it’s simply a matter of studying what works and what doesn’t. There is really no better way to do this than in a simulator.

If you haven’t already, we encourage you to give TradingSim a try for free and use the platform to study bear market strategies that might work for you.

Here’s to good fills!



 

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