What is a Bear Market?
A bear market exists when a financial market experiences price declines that last an extended period of time. Ordinarily bear markets exist in scenarios wherein the prices of securities fall by 20 percent if not more following recent highs. The market is characterized by pessimism and investor sentiment is negative.
Bear markets are oftentimes linked to declines that occur within the overall market or on an index like the Nifty 50. That being said, individual securities and commodities too can experience being in a bear market in the event that they witness a decline of 20 percent or more for a long time frame – ordinarily two months or more account for the same.
Bear markets may arise or accompany situations wherein the overall economy experiences a downturn which could be in the form of a recession. Bear markets can be viewed in comparison to their upward rising counterparts, bull markets.
Understanding What a Bear Market Entails
Stock prices are ordinarily indicative of what the anticipated future of cash flows and profits derived from a given company would amount to. In the event of growth prospecting waning and expectations being let down, the prices of stocks can witness a decline. Moreover, herd mentality, fear and the hurry to protect losses brought on by a downside can each contribute to extended periods of the sinking prices of assets.
Although there exist several definitions that outline what a bear market is, one stipulates that it arises in the event of stocks on average falling by 20 percent from their high. However, this is an arbitrary number. Bear markets can also be defined as those wherein investors are more likely to protect themselves from risks and be risk-averse rather than seek out risks in the market.
Bear markets are capable of lasting for months if not years during which time investors avoid speculating and instead seek out boring, more guaranteed bets.
Although there exist several reasons that can set in motion a bear market, most often, a sluggish economy or one that is weak can bring about a bear market. An economy that is slowing down is identified by several factors including low rates of employment, low levels of disposable income, poor productivity and declining business profits. Additionally, government interventions in an economy are also capable of setting in motion a bear economy. For instance, changes imposed to the tax rate can initiate a bear market. Moving on, in the event that investor confidence witnesses a decline, it can indicate the start of a bear market. Should investors believe that a certain outcome is likely in the near future, they act on the same. In this case, they most often sell their shares in order to avoid incurring any losses.
Bear markets are capable of spanning anywhere between several weeks or lasting several years. Secular bear markets for instance, are capable of being in existence from anywhere between 10 to 20 years and are characterized by returns that fall below average on a frequent basis. While there might exist rallies during periods of sustained bear markets during which time stocks or indexes rally for a certain time frame, the gains acquired during this time aren’t sustained and prices fall back to their previously lower levels. In contrast, cyclical bear markets ordinarily exist for a few weeks or may stay in existence for several months.
Understanding the Phases of a Bear Market
Bear markets are most often characterized by four distinct phases which are as follows.
Phase one is made up of high prices interspersed with investor sentiment being high. However, as this phases wanes out and reaches the end of its course investors begin to exit markets such that they can take in their profits.
Phase two views stock prices beginning to experience sharp falls, drops occur in trading activity and corporate profits begin to decline. Moreover, economic indicators which might have previously been positive begin to fall below the average. Some investors might begin to worry or panic while the investor sentiment begins to decline. This phase of time is known as capitulation.
Phase three occurs when speculators begin to enter the market owing to which some prices begin to rise along with the volume of trades carried out.
Phase four serves as the final phase and it witnesses prices continuing to decline, however this decline occurs at a slow pace. The low prices and positive news begin to capture the interest of investors once again as a result of which bear markets pave the way for bull markets to commence.
Short Selling During a Bear Market
Investors are capable of accruing gains during a bear market by taking advantage of short selling. This strategy requires the sale of borrowed shares which are then bought back at lower prices. This strategy is extremely risky and is capable of incurring major losses in the event that events don’t transpire as planned. Short sellers are required to borrow shares from a broker prior to placing a short sell order. The profit and loss acquired by a short seller amounts to the difference that exists between the price at which the aforementioned shares were sold and then bought back and is known as “covered”.
Inverse ETFs and Puts During Bear Markets
With the aid of a Put option, investors and traders alike have the freedom without being tied down with the onus of selling a specific stock at a specified price on or prior to a specified date. Put options are made use of in order to speculate the falling prices of stocks and hedge against these falling prices such that long-only portfolios can be protected. When bear markets aren’t in existence purchasing puts is ordinarily safer than engaging in the aforementioned short selling.
Additionally, inverse ETFS can be employed in order to speculate or safeguard portfolios. Inverse ETFs function by changing values in the opposite direction of the index they follow.
As established above, bear markets are capable of lasting time frames that might last a few months to being in existence for years on end. Investors can take advantage of short selling, put options and inverse ETFs in order to earn money during a bear market which is characterized by falling prices.