UNDERSTANDING BEAR MARKETS

Whether we like them or not, bear markets are part and parcel of market cycles and the process of investing. Traders and investors both need to understand the characteristics of bear markets to minimize risk and to take advantage of the opportunities they provide.

Bear markets versus corrections

The technical definition of a correction is a price decline of 10% or more in a major market index. If the decline reaches 20%, the index is technically in a bear market.

These are the technical definitions and are typically applied to an entire market. That doesn’t mean an index or individual security can’t be in a bearish trend or experience a correction that is smaller in magnitude. The price of an asset can also be in a bull trend on one time frame and a bear trend on another time frame.

A less specific definition would state that a correction is a countertrend move that isn’t large enough to upset the prevailing trend. A bearish trend would occur when the overall trend changes.

How long do bear markets usually last?

Stock market corrections average about one per year and last around a month or two. Prices usually recover from corrections in 6 to 10 months. Bear markets usually occur every 3 to 5 years and on average last about 6 to 18 months. Prices usually recover within 18 months but can take far longer to recover.

These periods are just averages, and an individual cycle can be very different. For example, the S&P500 took 10 years to recover after the Dot Com crash of 2000, and the current bull market has been going since 2009.

Bear market psychology

In this article, we are referring to bear markets that occur across entire markets. There is a big difference between a bear market that affects an entire market, rather than one affecting a single stock or sector. A broad market decline affects the overall behaviour of investors, rather than their outlook for a specific sector or security.

Bear markets are driven by fear. When an index is down 20%, most investors are down a similar amount, if not more. Rather than focusing on how much they can make from an investment; they begin to focus on how much they can lose. Bear markets are therefore often driven by momentum – the more an investor loses the more likely they are to sell their investments.

Smart investors sit back and look for opportunities. But they are not the ones driving the price action. Price action is driven by fearful investors as well as traders who are too eager to short the market with leveraged instruments.

Bear markets are characterized by rising volatility, severe price declines and – believe it or not – massive rallies. In fact, the largest rallies occur during bear markets, not during bull markets. There two bullish price moves that occur during bear markets that you should know about.

What is a dead cat bounce?

The first type of rally to know about is the dead cat bounce. This is a rally that occurs after a significant downtrend, but that quickly runs out of steam. Prices then continue falling.

A dead cat bounce is often triggered by positive news or a technical support level holding momentarily. A few brave buyers will enter the market, hoping the selloff is over. Sellers move their offers higher in the hope of getting a better price. However, as soon as the market realizes the buying is not sustained, the sellers once again become aggressive and the downtrend continues.

A dead cat bounce is a failed attempt to end the bear market, but there are not enough buyers and plenty of sellers on the sidelines.

The short squeeze

The second type of bear market rally is the short squeeze. Bear markets are caused by investors liquidating long positions. However, they also attract short sellers hoping to profit from price declines.

Short sellers often use leveraged instruments like futures and CFDs. This means their tolerance for losses is limited. They never know how much prices may rise either, so short-sellers are reluctant to hold on to short positions if the market goes against them.

If there are a lot of short positions and prices begin to rise, a squeeze will often occur. As each short position is closed, the price rises more, causing other short-sellers to be stopped out. A chain reaction will occur until all the short positions have been covered.

This will often result in prices rising too far – which means another selloff will occur.

How to approach a bear market

As mentioned, the price action during a bear market is driven by fear. Investors fear prices will fall further, while short-sellers fear prices will rise. Neither are focused on prices but on their potential losses.

Smart investors focus on the price and the types of stocks they are buying. The first thing to do is to make sure you are never in a position where your decision-making is driven by fear. You can use stop losses and diversification to limit your losses so that you don’t panic. When prices decline a lot, you should use the opportunity to buy high-quality companies that can withstand a recession, and that are trading at attractive prices.

As a trader, you should be looking for potential short squeezes to go long, and then take profits when momentum slows. The best time to open a short position is after a squeeze when prices are too high and begin to fall again. A dead cat bounce is also a good opportunity to go short as it proves that prices have further to fall.

The most important point to remember is to avoid making decisions based on fear. This will allow you to read the market clearly and make rational decisions to take advantage of irrational price action.

 

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This article may contain opinions and is not advice or a recommendation to buy, sell or hold any investment. No representation or warranty is given on the present or future value or price of any investment, and investors should form their own view on any proposed investment. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication. Non-independent research is not subject to FCA rules prohibiting dealing ahead of research, however we have put controls in place (including dealing restrictions, physical and information barriers) to manage potential conflicts of interest presented by such dealing.

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