Bear markets aren’t the most fun experience for investors, especially those new to the stock market. After all, share prices can fall aggressively in a matter of weeks or months, which isn’t exactly pleasant to see.
Having said that, bear markets in the UK and abroad can create exceptionally lucrative opportunities for patient investors. Let’s look at the exact definition of this investing phenomenon, how it differs from a bull market, and what to do to protect and grow wealth over the long term.
What is a bear market?
A bear market is a period of prolonged share price declines greater than 20%. Typically, this refers to the stock market in general, using the performance of an index like the FTSE 100 or FTSE 250, S&P 500, or Nasdaq as a proxy. But, while less common, it can also be used to describe the performance of an individual stock.
For example, during the 2008 financial crisis, the S&P 500 fell by approximately 50%, triggering a 17-month long bear market.
Looking at historical events, a common pattern emerges. And typically, a bear market occurs in four phases:
- Greed – The start of almost every bear market in the past was marked by exceptionally high stock valuations. Eventually, investors realise shares are trading too generously high and begin to take their profits.
- Capitulation – The sliding prices from the initial sell-off can trigger further sales, dragging stock prices down further. This often creates panic, resulting in a sharp decline in stock prices across the board.
- Speculation – Panic selling often results in widespread price declines even in solid companies that aren’t affected by the underlying problem that triggered the sell-off. Consequently, risk-taking investors start buying stocks at reduced prices, which can temporarily turn the tide. This is known as a bear market rally.
- Recovery – With most of the investing community prone to fear, share prices typically continue to fall, although more slowly. As companies begin to deliver better results, investor sentiment improves, pushing prices up, and triggering a new bull market.
Bear vs. bull market
Another piece of terminology often thrown around when things are going well is “bull market”. Strictly speaking, a bull market is a period of prolonged share price rises greater than 20% – the opposite of a bear market.
However, investors tend to be looser with its use, often marking the end of a bear market as a bull market, even before prices have actually started rising.
Bear market vs. market correction
Despite the terms “bear market” and “market correction” often being used interchangeably, there is a difference. Specifically, a market correction occurs when prices move by over 10%, making it less severe.
Note that a market correction can occur in either direction. Therefore, it doesn’t necessarily imply that the stock market is falling.
Why do bear markets happen?
Throughout history, there have been plenty of bear markets worldwide, and the UK is no exception. Like a stock market crash, each one was caused by different reasons, which underlines how unpredictable they are.
The list of catalysts for downward performance includes a weakening economy, sudden commodity price movements, irresponsible lending, widespread margin investing, valuation bubbles, geopolitical wars, and, more recently, pandemics, among other triggers.
However, the one thing all these causes have in common is uncertainty and fear.
Are we in a bear market today?
In the US, the S&P 500 along with the Nasdaq, are firmly in bear market territory. Both indexes have fallen by around 22% and 28% since their latest highs. But here in the UK, it depends on how investors measure the stock market.
Over the same period, the FTSE 100 has only fallen by around 8%, which doesn’t even qualify as a stock market correction. However, the performance of the FTSE 250 paints a very different picture, with the index falling by 22% since its latest high.
Given that the FTSE 250 covers a broader range of companies, many investors prefer it as a measure of general stock market performance. Therefore, it’s safe to assume that we’re in a bear market today in the UK.
How long do bear markets last?
The length of a bear market and subsequent recovery ultimately depends on what caused it. And they can span anywhere from a few weeks to potentially even years.
Shorter bear markets are known as ‘cyclical’. They are triggered by short-term disruptions that are often resolved within a few months. The longer kind are known as ‘secular’ bear markets. These are often triggered by corporate or economic growth stagnation that can take years or even decades to resolve. It’s worth noting that a secular bull market is also possible and quite common.
How often do bear markets occur?
While stock market crashes are quite rare, bear markets happen all the time. In 2014, the collapse of oil prices disrupted many oil-heavy indexes. Similarly, in 2018, a temporary change in monetary policy sent prices plummeting.
On average, a bear market occurs roughly every three and a half years, placing the 2022 bear market right on cue.
Should you sell in a bear market?
As strange as it sounds, the best move an investor can make during a bear market is nothing. A common adage in the investing community states, “buy low, sell high”. But when prices are seemingly in free-fall, most investors seem to forget this.
Unless there is a fundamental problem with the underlying company triggered by whatever has caused the bear market, selling is likely a terrible idea. Panic drags almost all stock prices down, even for strong businesses that aren’t affected by the problems everyone fears. And for these stocks, prices almost always recover before continuing to grow higher.
With that said, bear markets present excellent opportunities to snatch up high-quality shares while they’re on discount. But it’s critical to remember that only money not needed for at least the next three to five years should be used to buy stocks.
Are bonds a good investment in a bear market?
Traditionally, buying bonds during bear markets can be a sensible move. While there’s pessimism in the stock market, bond prices tend to climb as investors move their money into these “safer” assets. Although, it’s worth noting even with bonds, there is no guarantee of profitable returns.
So, should investors be thinking about buying bonds today? It’s difficult to say, but there are some unique factors at play right now, which may make it an unwise decision.
Historically, during economic downturns, central banks like the Federal Reserve and Bank of England tend to start buying up treasury bonds. This puts more money into the credit system and causes interest rates to fall. This makes it more attractive for consumers to buy and for businesses to invest, and encourages economic activity. But today, that monetary policy tool isn’t available. In fact, central banks are doing the complete opposite.
A number of factors, including pandemic-related shortages and ongoing supply chain issues, have contributed to high inflation that has severely dented investor confidence and raised fears of a recession. To counter this, central banks are now withdrawing money from the credit system through quantitative tightening. This pushes interest rates back up, in order to bring inflation back under control.
However, it also pulls current bond prices down. After all, why own an older bond when newer ones yield higher returns? With interest rates set to continue climbing, bond prices are expected to fall equally, suggesting that buying bonds in the current bear market may not be a prudent investment decision.
How to prepare for a bear market
If bear markets in the UK and abroad are inevitable, what can investors do to protect their portfolios?
1. Build a cash cushion
Selling during a bear market is a sure way to destroy wealth. Therefore, the last position any investor wants to find themselves in is being forced to close positions at low prices to meet either general living expenses or emergencies. Keeping a reasonable chunk of money in the bank can often eliminate this risk.
2. Plan ahead
When investing in any asset class like bonds or stocks, it’s important to remember the end goal. This is a core principle of wealth management. Investing money into the stock market is probably not a good idea if there are large upcoming expenses such as a down payment on a house. The stock market can be volatile, and there is no guarantee a position will be worth more in a few weeks or months. In fact, as many have recently discovered, it could be worth considerably less.
Predicting what will cause a bear market is hard. But a diversified portfolio is less likely to be overly exposed to the problem. Owning various businesses in different industries and potentially even different economies can be a powerful tool to mitigate the damage of a bear market environment.
4. Have capital to spare
Bear markets can present exciting buying opportunities for high-quality stocks that are simply caught in the panic-selling crossfire. Having a small portion of a portfolio as cash makes it possible to take advantage of these opportunities as and when they occur.
How to weather a bear market
Going through a bear market can be scary, especially the first time. So, what should investors do to weather the storm?
1. Focus on the long term
A key point to remember is that bear markets don’t last. Since the 1960s, bear markets have, on average, lasted 15 months. By comparison, bull markets last for around six years.
2. Buy quality companies
Not every stock will survive a bear market. There are countless examples of businesses going under during this time. However, firms with solid financial statements and a vast collection of competitive advantages not only tend to survive but also thrive. That’s why we constantly look for such companies in our Premium services.
3. Don’t try to time the market
Almost everyone who tries to predict when the stock market will crash or hit the bottom ends up being wrong. For reference, doomsayers have been predicting a stock market crash for the last 10 years, missing out on one of the greatest bull markets in history. Waiting to invest at the bottom often results in massive wealth-generating opportunities being lost. Instead, it’s better to focus on buying businesses for the long run, using any subsequent price fall as an opportunity to top up at an even better price.
4. Build positions over time
Tying into the previous point, investing all spare capital at the same time is likely going to end badly. Chances are, during a bear market, the price will continue to suffer for a while after buying shares. Therefore, it’s often a wiser move to invest in small chunks over the course of several weeks or months. That way, if prices do continue to fall, investors can add more shares of high-quality companies at better prices, bringing down the average price paid.
Bear markets often present incredible buying opportunities. Plenty of high-quality companies can see their stock prices tumble as investors panic. However, it's essential to understand why a stock is falling. Suppose the bear market has exposed a fundamental problem with the business. In that case, buying shares is likely a bad decision.
The terms "bear" and "bull" likely originate from how each animal attacks its opponents. Bears tend to swipe down while bulls attack upward.
However, another potential origin comes from bearskin traders who would sell skins they had yet to receive. These salesmen were effectively betting that the price of bearskins would fall in the near term to profit on the difference between the agreed selling price and the eventual buying price from trappers.
The longest bear market in history ended in 1942 after 61 months, and 60% of the S&P 500 had been wiped out.