Highlights.

  • Bear markets are caused by both economic and psychological factors.
  • Bear markets are inevitable, but knowing your tolerance for risk and the use of a strategic, rules-based investment approach can prepare you for them.
  • When a bear market does attack, stay calm and carry on.

 

Wild bears can go from disinterested to dangerous in a moment’s notice.  Accordingly, experienced outdoorsmen and outdoorswomen take precautions to prepare for a possible encounter before venturing into wilderness areas where bears are known to roam.  The case for prepping ahead of a trek through the backcountry is no less relevant when traveling through Wall Street’s jungles, where another type of bear attack is common.

 

The term “bear market” is commonly used to refer to a steep drop in the stock market because a wild bear tends to strike its prey using a downward motion.  Bear markets are as equally unpredictable as wild bears, which means that investors should remain ever vigilant for surprise attacks.

 

This week I will be discussing common causes for bear markets, how frequently they occur, how you can prepare for them, and what not to do when you encounter a bear market.

 

What is a Bear Market?

Although there is no one definitive definition of a bear market, perhaps the most widely accepted definition is a downturn of 20% or more in the price of the S&P 500 (or other broad stock market index) that continues for two or more months.  By comparison, a “correction” is a less severe, short-term downward trend of the market lasting less than two months.

 

Causes of Bear Markets.

There are a number of causes of a bear market.  Some are economic related, others can be attributed to investor behavior.

 

Economic:  Bear markets are frequently triggered by a weakened economy.  This makes sense because a stock’s price is a reflection of the issuing company’s projected future earnings.  If the economy weakens, the prospect for future earnings declines, pushing stock prices lower.

 

A financial system crisis can also trigger a bear market, as was the case in 2008-2009.  In that instance, the financial crisis was caused by banks trading in mortgage-backed derivatives.  Other possible triggers for a financial crisis include a credit crunch brought on by rising interest rates, unrestrained government borrowing resulting in currency devaluation, and either insufficient or excessive governmental regulation.

 

Behavioral:  Bear markets can also result from a widespread loss of investor confidence.  Market participants who lose faith in the future performance of a market will sell the stocks they own in an effort to minimize their losses.

 

Similarly, investors commonly over-estimate their risk tolerance, which can lead to emotionally driven decisions.  As a result, a drop in stock prices can cause large groups of investors to sell because the thought of enduring further declines in the value of their portfolios is more than they can tolerate.  But letting emotions take control typically leads to disappointing results because it leads to selling at or near bear-market bottoms.

 

A third behavioral cause of a bear market is “irrational exuberance”; a term coined by former Federal Reserve Chairman Alan Greenspan to describe the tech-stock bubble in the 1990s.  The term describes a situation where overly optimistic expectations about the prospects for future gains lead to widespread speculation by market participants, which in turn leads to a price bubble.  When the bubble bursts, a bear market ensues.

 

Frequency of Bear Markets.

Since 1929 there have been 25 occasions where the S&P 500 experienced a decline of at least 20% that lasted 2 or more months.

 

Preparing for Bear Attacks.

To Thyself Be True:  Perhaps the biggest mistake an investor can make is to let fear drive investments decisions.  The best precaution against a bear market is a clear understanding of your tolerance for market volatility and to invest accordingly.

 

Be Confident in How You Invest:  Confident investors are far less likely to make rash, costly decisions.  Using an academically sound, sensible, rules-based investment approach can instill the confidence required to not abandon ship when the seas get rough.  That’s because such strategies can be backtested many times to see how they would have performed under thousands of different circumstances (as I mentioned in a previous blog: Do you Feel Lucky?).

 

Diversify Your Investments:  Investing in a variety of asset classes that are negatively or weakly correlated (i.e., returns that tend to be independent of one another) can limit the decline a portfolio experiences during a bear market.  Government and municipal bonds, utility stocks, and commodities are examples of investments that have negative or weak correlation to stocks, and therefore adding these assets to your portfolio can dampen the effects of an extend market decline.  However, as the old saying goes, there is no such thing as a free lunch when it comes to investing.  Accordingly, even a diversified portfolio should be expected to under-perform an all stock portfolio during bull markets.

 

Rebalance Your Portfolio Periodically:  One of the traits common to most rules-based investment strategies is the use of target allocations for the various investments that are included in the portfolio.  Rebalancing is the practice of selling securities that exceed their target allocations and buying those that are under-weighted.  Rebalancing helps soften the blowback from bear markets because it causes investors to lighten up on positions in a portfolio whose prices are comparatively high, and to add to positions whose prices are comparatively low.

 

What Not to Do When You Encounter a Bear Market.

The U.S. economy cycles between peaks and valleys.  As a result, bear markets are inevitable, and you will almost certainly encounter one if you plan to be invested for the long term.  Here are a few suggestions on how to cope with a bear market.

 

Don’t Panic:  If you have adopted a well-designed and thoroughly tested strategy, there is no need to be overly concerned.  Keep in mind that bull markets (that is, a 20% or greater rally in stock prices) frequently follow bear markets.  Moreover, the early stages of a market recovery have usually provided the largest annualized returns.

 

Be Skeptical of Doomsayers:  Stock-market news channels profit from investor fear because bad news typically attracts more viewers.  Market gurus who appear on these channels are wrong more often than not, and are commonly trying to justify past mistakes and convince you to buy what they already own (and thereby drive the price of their investments higher).

 

Use Margin Cautiously:  Investing with borrowed money can magnify the losses during bear markets because you own a greater amount of stocks that have lost value.

 

The stock market is a complex trading system that behaves in unpredictable ways in the short term, which means that bear markets are inevitable.  Fortunately, prepared investors aren’t destined to be eaten when a bear market comes knocking.

 

The unprepared, on the other hand, could find themselves on the wrong side of the door – much like John Candy did in the movie “The Great Outdoors”.

 

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