What is a Bear Market? How They Occur and Investing in a Downturn

What is a bear market in stocks? 

Opinions vary, but most investors agree a bear market is a significant and prolonged drawdown in major averages like the S&P 500. But bear markets are complex creatures and don't necessarily mean it's time to panic. We'll walk through how bear markets work, how they've played out historically and how to position your portfolio to make it through drawdowns.

Overview and Basics of a Bear Market

Investors experienced two very different types of bear markets after the COVID-19 pandemic. One occurred as the pandemic strengthened, and market indices dropped by 30% in less than six weeks. The other occurred in 2021 as the pandemic began to recede, but this slow-moving bear market deterred investors with losses over a much longer period.

What is a bear market in the stock market, exactly? According to Investor.gov, the bear market definition is a decline of 20% or more over two months or longer. Investors or analysts who discuss a bear market refer to a decline in broad market averages like the S&P 500 or Dow Jones Industrial Average. Still, it's also not uncommon to refer to sectors or individual stocks as being in a bear market when they drop 20%.

What Causes a Bear Market?

Bear market history is littered with unique situations. In basic economic terms, the cause of a bear market is fairly simple: more sellers than buyers. The demand for stocks fades, and prices drop as sellers become more anxious to part with their shares. Supply and demand will always be an underlying factor influencing markets. 

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But let's look a little closer under the hood. Bear markets result from converging economic or political issues. Of course, as we saw with the COVID pandemic, an unexpected shock can also cause market averages to tumble. But singular causes are rare, and bear markets are most often the result of a combination of the following factors:

• Geopolitical events: Wars and pandemics are two recent examples of geopolitical events that can roil markets. Whenever uncertainty threatens governments or nations, markets tend to react poorly.
• Slowing economic growth: Bear markets are often considered a "canary in the coal mine" for stalling business growth or recessions. A bear market could brew when individual companies start seeing costs increase or sales slow.
• Fiscal or monetary policy: Congress and the Federal Reserve can also negatively affect asset prices. If business taxes are raised too high, companies might lose profit and suffer a decrease in share prices. The Fed can also cool rising stock prices by raising interest rates and increasing business capital costs. 
• Asset bubbles deflating: The ebb and flow of asset prices is a natural process in markets. But the result isn't a timely slowdown when asset bubbles appear, like the dot-com bubble or the housing bubble preceding the Great Recession. Crashes and bear markets frequently occur when bubbles burst as the flow of new capital ceases and formerly exuberant investors flood the exits.

Bear Market Phases

Bear markets don't always follow the same pattern, so the best advice for long-term investors is to stay the course. For example, everyone remembers the massive drawdowns during the Great Recession and the outbreak of the COVID-19 pandemic, but not so much the S&P 500's 20% contraction in Q4 2018.

If you're looking for a bear market blueprint, you might be searching for a while. Bear markets history is often filled with unexpected gains (bear market rallies) that confuse and frustrate investors. 

That said, if you want to break it into stages of a bear market, here is the most common sequence of events:

• Catalyst: Some catalyst usually kicks off bear markets, whether it's poor earnings reports, bad economic data, high-profile events like wars and pandemics or just good old-fashioned profit-taking. Sometimes this catalyst isn't always clear. When markets declined in 2018, experts gave various reasons for the poor performance.
• Volatility: Have you ever heard, "Stocks take the stairs up and the elevator down?" This metaphor commonly appears in bear markers as drawdowns steepen and volatility increases. But short selling at this stage isn't always a sure thing! For example, Dow bear markets often see some of the biggest single-day gains on record. The DJIA has gained 10% or more daily on eight occasions, all occurring during bear markets (1929, 1931, 1932, 1933, 1987, 2008 and 2020).
• Grinding market action: Bear market trading is partly difficult because the drawdown tends to happen quickly, but the recovery frequently stalls. Markets tend to trade in a range during the midpoint of the bear markets, giving both buyers and sellers headaches over the direction of the trend. This bear market phase can last for months or even years in the cases of the Great Depression and Great Recessions.
• Capitulation and recovery: Markets often aren't satisfied until they've confounded every institution and investor, usually leading to capitulation. Even the strongest holdouts begin to unload their stocks for safer assets. Bear markets start fizzling when earnings or economic data slowly improve and investors begin re-entering the market.

How to Invest or Trade in a Bear Market

What does a bear market mean for investors? It depends on your timeframe. Young investors just beginning to compile assets should welcome bear markets as it gives them a chance to enter with cheap stocks. 

However, if you have short-term goals, a bear market could severely hinder your objectives. Whatever your goals are, you'll need a plan of attack for bear markets. Here are a few quick steps to keep in mind when markets are dropping.

Step 1: Don't panic sell.

Remember this advice from your mother — don't do something just because everyone else is doing it. Watching your account balance decline triggers an emotional response, which is why so many people dump their assets during times of trouble. This doesn't mean you should never sell in a bear market, but the selling should be calculated and done with long-term goals in mind.

Step 2: Review your investment plans and goals.

Reviewing your investment plans and ensuring you aren't acting irrationally is never a bad idea during bear markets. Bear markets are inevitable if you invest long enough, so don't treat every drawdown as a life-altering emergency. Having a prebuilt strategy for bear markets will help you stay calm and think clearly.

Step 3: Look for opportunities or continue to dollar-cost average.

Here's where your investment style matters. If you have a long-term investment approach, consider bear markets as an opportunity to dollar-cost average into cheaper stocks. Even the steepest drawdown has represented an opportunity for investors with a multi-decade time horizon. For traders with shorter time horizons, bear market volatility can present opportunities for quick gains.

Step 4: Avoid trying to time the market.

One of the worst strategies is selling all your assets and waiting for the turnaround. First, you can never be sure if the market will fall further after you sell your stocks. And second, you also can never be sure you'll properly identify the bottom and promptly buy back in. Market timing is often a money-losing strategy, so don't attempt it unless you're experienced and have a good reason to believe you can pull it off.

Learn more: 5 Best Stocks to Buy in a Bear Market and 7 Best Bear Market ETFs

Bear Markets Can Offer Opportunities, but Plan

What is a bear run in the stock market? Whether you have long-term or short-term goals, bear markets can be opportunities to buy stocks at a discount. But successfully navigating a bear market requires sticking to the rules. Investors saving for a far-off retirement should stick to their goals and continue contributing to their IRAs or 401(k) accounts. A bear market is just a blip on the radar if you have a long enough view.  

Additionally, short-term traders can leverage bear market volatility to find opportunities. But the crucial thing to remember is that bear markets are a natural occurrence and can even be a good thing if irrational bubbles need popping (NFTs, anyone?). When prices drop, you need a plan and the emotional intelligence to stick with it.

FAQs

Is the market turning around? Here are a few frequently asked questions about bear markets and how investors should behave when they occur.