Understanding Bear Markets: Phases, Examples, and Investment Tips

A bear market occurs when financial markets experience a decline of 20% or more. This is often marked by falling prices and growing investor pessimism. These downturns are usually triggered by factors that weaken investor confidence, such as economic slowdowns, rising inflation, or geopolitical tensions. This article explores the key phases of a bear market, examples from recent history, and effective investment strategies to help navigate and potentially take advantage of these challenging market conditions.

Detailed Insights Into Bear Markets

Stock prices generally reflect how investors expect companies to perform. If a company has lower-than-expected profits, or experiences less growth than analysts predicted, investors may respond by selling the company's stock, which makes the overall price decline. The combination of herd behavior and fear can create a rush to minimize losses, which in turn can lead to prolonged periods of depressed asset prices.

One definition of a bear market says markets are in bear territory when stocks, on average, fall at least 20% off their high. But 20% is an arbitrary number, just as a 10% decline is an arbitrary benchmark for a correction. Another definition of a bear market is when investors are more risk-averse than risk-seeking. This kind of bear market can last for months or years as investors shun speculation in favor of boring, sure bets.

Bear markets can be caused by weak economies, market bubbles bursting, pandemics, wars, geopolitical crises, or big shifts like moving to an online economy The signs of a weak or slowing economy are typically:

• Low employment
• Low disposable income
• Weak productivity
• Drop in business profits

Government interventions in the economy can also trigger a bear market. For example, changes in the tax rate or the federal funds rate can lead to a bear market. Similarly, a drop in investor confidence may also signal the onset of a bear market. When investors believe something is about to happen, they will take action—in the case of an imminent bear market, selling off shares to avoid losses. 

Bear markets can last from a few weeks to many years. A secular bear market can last anywhere from 10 to 20 years and is characterized by below-average returns on a sustained basis. There may be rallies within secular bear markets where stocks or indexes rally for a period, but the gains are not sustained, and prices revert to lower levels. A cyclical bear market, on the other hand, can last anywhere from a few weeks to several months.

Notable Bear Markets in Recent History

The U.S. major market indexes were close to bear market territory on December 24, 2018, falling just shy of a 20% drawdown. More recently, major indexes including the S&P 500 and Dow Jones Industrial Average (DJIA) fell sharply into bear market territory between March 11 and March 12, 2020. Prior to that, the last prolonged bear market in the United States occurred between 2007 and 2009 during the Financial Crisis and lasted for roughly 17 months. The S&P 500 lost 50% of its value during that time.

In February 2020, global stocks entered a sudden bear market in the wake of the global coronavirus pandemic, sending the DJIA down 38% from its all-time high on February 12 (29,568.77) to a low on March 23 (18,213.65) in just over one month. However, both the S&P 500 and the Nasdaq 100 made new highs by August 2020.

The Four Phases of a Bear Market Cycle

Bear markets usually have four different phases.

First Phase of a Bear Market

The first phase is characterized by high prices and high investor sentiment. Towards the end of this phase, investors begin to drop out of the markets and take in profits.

Second Phase of a Bear Market

In the second phase, stock prices begin to fall sharply, trading activity and corporate profits begin to drop, and economic indicators, that may have once been positive, start to become below average. Some investors begin to panic as sentiment starts to fall. This is referred to as capitulation.

Third Phase of a Bear Market

The third phase shows speculators start to enter the market, consequently raising some prices and trading volume.

Fourth Phase of a Bear Market

In the fourth and last phase, stock prices continue to drop, but slowly. As low prices and good news starts to attract investors again, bear markets start to lead to bull markets.

Distinguishing Bear Markets From Market Corrections 

A bear market should not be confused with a correction, which is a short-term trend that has a duration of fewer than two months.

While corrections offer a good time for value investors to find an entry point into stock markets, bear markets rarely provide suitable points of entry. This barrier is because it is almost impossible to determine a bear market's bottom. Trying to recoup losses can be an uphill battle unless investors are short sellers or use other strategies to make gains in falling markets.

Between 1900 and 2018, the Dow Jones Industrial Average (DJIA) had approximately 33 bear markets, averaging one every three years. A key bear market recently happened during the global financial crisis from October 2007 to March 2009. During that time the Dow Jones Industrial Average (DJIA) declined 54%. The global COVID-19 pandemic caused the most recent 2020 bear market for the S&P 500 and DJIA. The Nasdaq Composite most recently entered a bear market in March 2022 on fears surrounding war in Ukraine, economic sanctions against Russia, and high inflation.

Leveraging Short Selling During Bear Markets 

Investors can make gains in a bear market by short selling. This technique involves selling borrowed shares and buying them back at lower prices. It is an extremely risky trade and can cause heavy losses if it does not work out. A short seller must borrow the shares from a broker before a short sell order is placed. The short seller’s profit and loss amount is the difference between the price where the shares were sold and the price where they were bought back, referred to as "covered."

For example, an investor shorts 100 shares of a stock at $94. The price falls and the shares are covered at $84. The investor pockets a profit of $10 x 100 = $1,000. If the stock trades higher unexpectedly, the investor is forced to buy back the shares at a premium, causing heavy losses. 

Using Puts and Inverse ETFs to Navigate Bear Markets

A put option gives the owner the freedom, but not the responsibility, to sell a stock at a specific price on, or before, a certain date. Put options can be used to speculate on falling stock prices, and hedge against falling prices to protect long-only portfolios. Investors must have options privileges in their accounts to make such trades. Outside of a bear market, buying puts is generally safer than short selling.

Inverse ETFs are designed to change values in the opposite direction of the index they track. For example, the inverse ETF for the S&P 500 would increase by 1% if the S&P 500 index decreased by 1%. There are many leveraged inverse ETFs that magnify the returns of the index they track by two and three times. Like options, inverse ETFs can be used to speculate or protect portfolios.

Historical Case Studies of Bear Markets 

The housing mortgage default crisis hit the stock market in October 2007. Back then, the S&P 500 had touched a high of 1,565.15 on October 9, 2007. By March 5, 2009, it had crashed to 682.55, as the extent and ramifications of housing mortgage defaults on the overall economy became clear. The U.S. major market indexes were again close to bear market territory on December 24, 2018, falling just shy of a 20% drawdown.

Most recently, the Dow Jones Industrial Average went into a bear market on March 11, 2020, and the S&P 500 entered a bear market on March 12, 2020. This followed the longest bull market on record for the index, which started in March 2009. Stocks were driven down by the onset of the COVID-19 pandemic, which brought with it mass lockdowns and the fear of depressed consumer demand. During this period, the Dow Jones fell sharply from all-time highs close to 30,000 to lows below 19,000 in a matter of weeks. From February 19 to March 23, the S&P 500 declined 34%.

Other examples include the aftermath of the bursting of the dot com bubble in March 2000, which wiped out approximately 49% of the S&P 500's value and lasted until October 2002; and the Great Depression which began with the stock market collapse of October 28-29, 1929.

The Bottom Line

A bear market is a decline of 20% or more in market prices, often accompanied by negative investor sentiment and weakening economic conditions. These downturns can vary in duration, lasting anywhere from a few weeks to several years. Bear markets may present opportunities to buy quality stocks at lower prices for long-term investors, while short-term traders may employ strategies like short selling, buying put options, or investing in inverse ETFs. But this could come with risks. Bear markets are typically triggered by factors like economic slowdowns or investor panic. Because it’s difficult to pinpoint the exact bottom, patience and disciplined decision-making are needed to navigate them successfully.