What a bear market means for traders

Global stock indices suffered a shocking start to 2022. After rallying in more or less a straight line for twenty months following the pandemic low of March 2020, cracks began to appear in the major financial markets. In November 2021, the tech heavy NASADAQ 100 stalled after hitting a succession of record highs. The S&P 500 managed to register several fresh highs before topping out in early January this year. Since then, it’s been nothing but misery for the bulls. By mid-May, the NASDAQ and S&P 500 were down 31% and 20% respectively from their record highs. This was enough for market commentators to start shouting about US equites being in ‘bear market’ territory. But what does that mean? And more importantly, does knowing we’re in a bear market help with your trading?

What is it?

First, a definition. According to Investopedia, a bear market: ‘…typically describes a condition in which securities prices fall 20% or more from recent highs amid widespread pessimism and negative investor sentiment’. OK, so now we know. If a security loses a fifth of its value, it is ‘officially’ in a bear market. I’m not sure where the 20% comes from. But it represents a significant loss, so let’s go with it. But as Investopedia also states, and as most commentators overlook, a bear market isn’t just about a loss of 20%. A bear market decline should be ‘prolonged’ and ‘amid widespread pessimism’. There’s little doubt that investor sentiment will be negative if the value of a market is reduced by a fifth. But what about the duration of the decline? Back in March 2020, stock markets slumped as the pandemic took hold. The NASDAQ fell 31% while the S&P 500 lost 35%. The loudest voices were screaming that we were in a bear market, and markets had further to fall. Anyone who disagreed was roundly mocked. But those losses marked the bottom of a sell-off which lasted just one month. Sure, the slump was traumatic and frightening, but within three months the NASDAQ had recovered all off its losses and went on to hit a fresh record high. Two months later, the S&P 500 had done the same. As far as the percentage falls were concerned, both the S&P 500 and NASDAQ hit bear market territory in around three weeks after the sell-off began. Two weeks later, the bottom was in.

This time it’s different

This is where the current sell-off differs from 2020. While the S&P only briefly dipped into bear market territory in percentage terms, the NASDAQ is still more than 20% lower than its November high. So, conflicting signals. In addition, this decline has been going on for over six months now. And while both the S&P 500 and NASDAQ have bounced off recent lows, there’s still a possibility that the selling could resume. Could it be that we’re in for something more protracted? Let’s look at two other notable bear markets. The beginning of this century saw the Dotcom crash. The S&P 500 lost half of its value. But it didn’t happen overnight. It took over two and a half years between March 2000 and October 2002, of grinding lower with every rally eventually fading out on a raft of selling. Then, the Great Financial Crisis saw the S&P lose 58% over a period of seventeen months, October 2007 to March 2009. Again, this was a dispiriting time for those investors who saw value in beaten-down stocks but were persuaded not to buy due to overwhelming negative sentiment. Could this be what we’re experiencing now? Bear in mind, we’ve been in a bull market ever since the S&P 500 hit its low of 666 in March 2009. There have been some setbacks along the way, most significantly the 20% sell-off in the S&P between September and December 2018. But aside from that, the biggest correction until now was the pandemic

Psychological

A 20% sell-off in a financial market is just one factor of a bear market. It’s both a symbol and a psychological hurdle for investors. Sure, at 20% down sentiment is negative. That’s why bear markets often accompany general economic downturns and recessions. As we know, we had a whiff of a recession indicator earlier this year when parts of the US Treasury yield curve inverted. It was so brief as to be meaningless, but it has put recession fears on the menu, and these are adding to negative sentiment. But the market sentiment around the Dotcom crash and the Great Financial Crisis was really ‘End of Days’ stuff. With the former, billions of investment dollars evaporated into thin air over a protracted period, on a revaluing of internet start-ups. With the latter, the world was on the brink of a total banking collapse. More recently, consider the genuine fear and uncertainty as the pandemic took hold. A horrible disease with no vaccine, and global health services on the verge of collapse. Governments around the world responded by shutting down huge swathes of the economy. Is that how things are now, as central bankers attempt to normalise monetary policy and reduce stimulus? Sure, the outlook is concerning, and we’d be daft to put our trust in policymakers and central bankers to engineer a soft landing or navigate a risk-free future. But that doesn’t mean we’re on course for a protracted bear market. Yet. We could be. After all, stock markets crash, and when they do the world will be in an even more worrying place than it is now. But it’s also possible that we’re currently experiencing a prolonged correction within a bull market that has further to run. If so, when every bear has turned bullish, it will be time to get out.