What is a bear market and how do you trade one?

What is a bear market?

A bear market is defined as a sustained fall in prices, by 20% or more, from a recent high. Bear markets can occur in specific stocks, asset classes or the market as a whole. The most common benchmark for bear markets is the S&P 500.

The 20% level is just a threshold, as bear markets often go beyond that and can even be accompanied by an economic recession. On average, stocks fall 36% in a bear market, according to Ned Davis Research.

Correction vs bear market vs recession

A stock market correction is a fall of less than 20%, occurring when the market becomes considered overbought and investors close their positions. The market price falls to a price that more accurately reflects the asset’s true value before investors are willing to step in again.

In between a correction and a bear market, lies a market crash. There’s not a set definition of a crash, but it’s usually a 10% or more fall from a recent high and has to last a few days or weeks.

A decline of 20% or more enters bear market territory. While corrections occur frequently, bear markets are a more significant market event, which can even provoke government intervention. Although a bear market and recession normally coincide, the root causes are very different. A recession is the result of an economic contraction and is generally defined as at least two consecutive quarters of declining GDP. Whereas a bear market is the result of changing investor sentiment.

So, while financial markets and the economy are inextricably linked, the correlation isn’t as straightforward as ‘if there’s a recession, there will be a bear market’ and vice versa. Especially given that there are markets that rise during a recession.

What causes a bear market?

A bear market is caused by negative sentiment, which leads individuals to move their money out of risk-on asset classes, such as stocks, energies and currencies, and into fixed-income securities and safe havens – such as gold.

This shift in psychology causes prices to decline as capital flows out of markets. Market participants become so pessimistic that they even ignore positive news – such as strong earnings reports – and just continue to push prices lower.

Bear markets are typically associated with a weakening economy in which consumers are becoming unwilling to spend money due. At this point, investors might decide to close their positions in the expectation that businesses will see profits decline.

Investors and traders will be watching key economic indicators – such as wage growth, employment rates, inflation and interest rates – to see whether a slowdown is taking place before making any decisions.

Bull market vs bear market

While a bear market is a sustained decline in asset prices, a bull market is a sustained increase in prices. During a bull market, investors believe that the uptrend will continue for a long period of time and are willing to buy into a market at higher and higher prices. This generally happens when the economy is strong and there’s a high appetite for risk.

In a bull market, demand for assets is strong but the supply is limited, which sends prices higher as investors add competing bids. The opposite happens in a bear market, as market participants rush to close their positions, supply floods the market and there’s little demand – meaning investors have to accept lower and lower prices in order to close.

Learn more about supply and demand.

How frequent are bear markets?

There have been 14 bear markets between 1945 and 2021, which means that bear markets occur, on average, every 3.6 years. They used to be significantly more frequent pre-World War II, when there were 12 bear markets between 1928 and 1945 – or one every 1.4 years.

How long do bear markets last?

On average, bear markets last 363 days. Historically, bear markets are short lived, especially when compared to bull markets, which have an average length of 1,742 days.

However, some bear markets have lasted for years. The longest bear market was in 1973, during the Great Depression, which lasted 61 months. The longest bear market of the last 20 years coincided with the 2008 financial crisis. It started in 2007 and lasted 1.3 years – the S&P 500 fell by 51.9%.

The different lengths of bear markets have different names:

1. Cyclical – these last a few months or a year
2. Secular – these last longer than a year

When do bear markets end?

Bear markets end when prices rebound 20% from their last low, which would now be considered the start of a bull market. The bottom of a bear market takes place when prices reach levels that investors are willing to buy at again, and the market stabilises.

If the bear market coincides with a recession, the bottom of a bear market often takes place around the same time as economic indicators start showing growth. Consumer and business confidence returns, and profits start to climb, marking the start of the recovery.

How to weather a bear market

During a bear market, the chances of losses increase for both long-term investors and short-term traders in long positions. So, there are three options: ride it out, close positions, or open new trades. 

To weather a bear market, it’s important to be aware of the trends that take place and where money flows move to. There are a few asset classes that typically rise during broader market downturns because they’re used by investors looking to limit risk through diversification. This means they also create an opportunity for speculative traders to profit.

These include:

• Bonds – fixed-income securities are used in downturns as they guarantee income and typically rise in value when stocks fall. US Treasuries in particular are watched during periods of downturn due to their backing from the largest economy in the world
• Precious metals – gold and silver are both viewed as safe havens during financial crises, which means investors flock to them and push prices up
• Defensive stocks – these companies are less affected than the wider market due to the continued demand for their products giving them a stable balance sheet. Defensive stocks include businesses such as consumer staples and utilities

It can also be tempting to try and identify the bottom of a bear market to enter new positions that take advantage of the rebound that follows. However, buying in the hope of an upturn can be dangerous, and you may take on even more losses before the market rebounds. When looking at reversals, ensure you’ve received a few confirmation signals to avoid entering at a false bottom.

How to short a bear market

For traders, a bear market presents a different opportunity: going short on falling markets. Short selling is the practice of opening a position on a market you expect to decline in price, with the aim of buying the asset back at a lower price – the difference between the higher and lower price would be your profit.

This process used to be complicated as it involved borrowing assets from third parties to sell. But using derivatives, you can go short on a range of assets, such as stocks, indices, commodities and currencies, without ever needing to own the underlying asset.