When navigating the financial markets, today’s investors may often feel as if they’re walking through a minefield. Bear markets are the most difficult environments for investors. These times of breath-taking fall can really tempt the spirit of the best-prepared veterans. OverTraders.com aims to provide clarity and actionable strategies to help you understand, prepare for, and even thrive during these downturns.

What is a Bear Market?

So understanding bear markets is super important to investors. It prepares them to be better stewards of their portfolios and pounce on opportunities as they come. A bear market is more than a brief marked decline. This serves as an important indicator of a larger, troubling tide—a significant shift in market sentiment and overall economic conditions.

Overview of Bear Markets

Pandemic-related issues pushed the world into a bear market, defined as a 20% drop in the stock markets lasting more than two months. More specifically, this decline is at least 20% from their most recent highs. This decline is often measured in months, or many times years. It illustrates the depth of pessimism and the pervasiveness of selling pressure in eroding investor willingness to take risks.

Bear markets often accompany economic recessions. They are equally unavoidable when they occur by necessity due to geopolitical turmoil, sudden economic shocks, or popping asset bubbles. The distinctive feature is a prolonged slump driven by pernicious investor mood.

There are different types of bear markets, each with its own characteristics and implications:

Cyclical Bear Market: These are shorter-term downturns that occur within a larger economic cycle, typically lasting from several months to a few years. Deep and/or prolonged recessions are most often birthed by rapid, excessive increases in interest rates, fed by dour economic growth or (sometimes) earnings contraction.

These are longer-term downturns that can last for a decade or more. They fail to produce average returns, on the whole, repeatedly turning in subpar results. These trends usually go hand in hand with major inflection points in the economy or changes in investor sentiment. Secular bear markets aren't one long slide downward, either: During "bear market rallies," for instance, stock prices rise for a time before plunging again to new lows.

Event-Driven Bear Market: These are triggered by unexpected external shocks, such as wars, pandemics, or geopolitical crises. They are often more short-lived and can rebound almost immediately once the acute crisis is over.

Nothing is written in stone but historically a new bear market can last anywhere from a few weeks to 3+ years. This variation is due to what caused the drop, and the economic context involved. For reference, a bear market officially ends when the market is up 20% from its lowest point. This recovery is no exception, much longer than the duration of the upswing that normally marks the end of a recession.

Recent Examples of Bear Markets

Looking at past bear markets can help investors understand how bear markets tend to behave, what impact they may have on a diversified investment portfolio, and more. Several notable bear markets have occurred in recent history, each triggered by unique circumstances:

This bear market was triggered by the collapse of the U.S. housing market and the subsequent credit crisis. At 17 months running, it was the longest DJIA drop ever at that time, with the DJIA falling 54%. The crisis precipitated mass bank insolvencies, a worldwide depression, and trillions of dollars in losses for investors.

This bear market was triggered by the onset of the COVID-19 pandemic and the resulting economic lockdowns. During the COVID market crash, the S&P 500 dropped by 34% from February 19 to March 23, 2020. That fall constituted one of the quickest bear markets in history. Then came a quick rebound as governments and central banks pumped historic amounts of stimulus into the economy.

The 2000-2002 Dot-Com Bubble Burst: This bear market was triggered by the bursting of the dot-com bubble, which had seen a surge in internet-based companies with unsustainable valuations. The tech-heavy index composite of the Nasdaq—where Amazon and Zoom were headquartered—had an epic fall off. For example, it fell almost 80% from its high in March 2000 through its trough in October 2002.

Two major bear markets in history are notably different. The 1973-1974 bear market was largely spurred on by the oil embargo and increasing global tensions, while the 1929-1932 Great Depression was caused by economic disparities, excessive speculation and the fallout from the Spanish flu pandemic.

Stages of a Bear Market

Bear markets are often negative in clear stages, each driven by unique investor psychology and market factors. Recognizing these phases allows investors to be proactive, stay ahead of possible market shifts, and make more informed investment decisions.

Initial Phase

The first stage of a bear market is usually marked by some degree of complacency and denial. Share prices can be very inflated, and investor mood dangerously euphoric, even when vulnerabilities lie just beneath the surface. This step is where things get tricky. It is easy for investors to believe that the market will continue to rise or that any correction will be quick and shallow.

In every cycle, during this phase, early warning signs start to bubble up, whether it’s deteriorating corporate earnings, increasing interest rates or geopolitical chaos. In this multifactor world, some investors will fail to notice these markers. Perhaps they are just still trapped in workflow largely created by the last bull market’s momentum.

Intermediate Phase

While the bear market continues, the second phase involves the realization of economic trouble by investors, signified by falling stock prices. Investors are realizing that the first canaries in the coalmine were not a blip. The market is facing even bigger challenges on the horizon. Profit-taking accelerates and fear starts to take hold of the market.

While in this phase, classic bear market rallies can bring countertrend relief to a weary investor base. Like all sharp bear market rallies, they are often a temporary phenomenon resulting in deeper market retreats as the underlying catalysts for declines have not changed. We would not be surprised if most investors take these rallies as near-term sells to lighten their holdings and/or risk to the market.

Declining Phase

The third phase, which is often the longest in duration, is marked by a steep liquidation of stock values. You’ll see a panic sell off as investors try to be the first to the door before prices continue to drop and losses accelerate. This challenge of this phase is the biggest hurdle. Predicting how far the market will drop and how long the downturn will continue is usually challenging.

During this phase, bad news and bad economic data flood the news cycle, which unfortunately self-perpetuates investor confidence. What too often happens is that many investors get paralyzed by fear and inaction, rendering them unable to make rational, sound decisions.

Recovery Phase

The fourth phase, or the stock market bubble busting phase, is marked by a gradual decrease in equity values. The market isn’t still on the downslide, but rather things are leveling off. Some investors are beginning to see an attractive opportunity in the devalued shares. This phase is often a time of bearish consolidation, as the market looks for a bottom.

This stage is when more contrarian investors start to load up on deeply discounted stocks, betting on an inevitable rebound. Not surprisingly, timing the bottom of the market can be difficult. Investors need to be patient and disciplined in this process.

Distinguishing Bear Markets from Corrections

It is crucial to clarify the difference between a bear market and a market correction. While both terms refer to declines in stock prices, they differ in their severity and duration. Knowing the difference will go a long way to ensuring more accurate and informed decisions by investors.

A bear market is when the stock market loses more than 20%. A market correction is a decline of more than 10% but less than 20%. As a reminder, corrections occur much more often than bear markets. They are typically less extensive, frequently running only for a few weeks or months. They are typically triggered by short-term events or concerns, such as profit-taking, economic data releases, or geopolitical developments.

In opposition, a bear market is a more extended drop of 20% or more in major stock market indices. Bear markets are the rarer cousin of corrections. They usually last from a few months to a few years. They are often set in motion by deeper forces, like economic downturns, financial crises, or popping asset bubbles.

The 20% threshold is somewhat arbitrary, but it is widely used as a benchmark to distinguish between a bear market and a correction. Unlike previous steep drops, this one has been more drastic and longer lasting. A correction is generally considered to be a short-term downturn in the market. A bear market, by comparison, is a sustained decline that lasts at least several months and often stretches into years.

Investment Strategies During Bear Markets

Surviving a bear market takes an entirely different approach compared to when the market is bullish. Whatever you do, don’t panic and sell everything! Instead, avoid the doom and gloom and adopt one of the proactive strategies discussed below that will not only protect your capital but generate returns during a downturn.

Short Selling Techniques

Short selling is a very aggressive strategy. This practice consists of borrowing shares of a given stock and selling them in the market—i.e., shorting the stock—hoping that the stock price will decrease. If the stock price decreases, the short seller will be able to return the shares by purchasing them back at a lower price point. They then return the shares to the lender and pocket the difference as profit.

Short selling is a very dangerous strategy. Short selling can be an infinite loss situation. If the stock price increases, the short seller is in a very difficult position. They will now need to repurchase the shares at the new increased price, incurring a lost position. Short selling can be a useful hedge for declines in the market overall or to otherwise make money on overvalued stocks.

Utilizing Puts and Inverse ETFs

A second strategy for riding out bear markets is put options and inverse exchange-traded funds (ETFs).

Put Options: A put option gives the buyer the right, but not the obligation, to sell a stock at a specified price (the strike price) on or before a specified date (the expiration date). If the stock price goes below the strike price, the put option increases in value. This exercise gives the home buyer a chance to cash in on the home price decline. Put options can be used to hedge against potential losses in a portfolio or to speculate on a decline in a specific stock.

  • Inverse ETFs: Inverse ETFs are designed to provide returns that are the opposite of the performance of a specific index or asset class. As the name suggests, an inverse S&P 500 ETF would go up when the S&P 500 goes down. Inverse ETFs can be a good way to hedge your portfolio from an expected market decline or to simply look to profit off a bear market.

Real-Life Case Studies of Bear Markets

Learning from actual historical examples of bear markets can offer important lessons and insights for all investors. By studying how different asset classes and investment strategies performed during past bear markets, investors can better prepare themselves for future downturns.

By comparison, U.S. government bonds and gold soared in value throughout that stormy stretch. This reinforces the necessity of diversification and the advantages of bear-market safe-haven asset ownership.

Not only did tech stocks perform extremely well all throughout the 2020 bear market caused by COVID-19, but they came roaring back. Where companies that enjoyed a flexible remote work policy thrived, travel and hospitality industries suffered devastating blows. You have to know how the economic tides are shifting. Avoid the temptation of searching for the next best company to survive a downturn.

Conclusion and Key Takeaways

Bear markets are simply an unfortunate building block of the investment cycle. Though they are difficult and nerve-wracking, there are opportunities for prudent investors. By understanding the causes of bear markets, recognizing their stages, and implementing appropriate investment strategies, investors can protect their capital and even profit from these downturns.

Key takeaways from this discussion include:

A bear market is defined as a sustained drop of 20% or more in general stock market indices.

Bear markets are often brought on by economic recessions, financial crises, or black swan external shocks.

Bear markets usually develop in three identifiable stages, each marked by a unique mood among investors and conditions within the market.

Understanding the difference between bear markets and corrections will help you make better investment decisions.

Here are four investment strategies to help you weather bear markets. Explore short selling, using put options or investing in inverse ETFs.

By looking at actual historical examples of bear markets, we can glean important lessons and insights that will help better equip investors to respond appropriately.

By staying informed, remaining disciplined, and adapting their strategies to changing market conditions, investors can navigate bear markets successfully and emerge stronger on the other side.