Sharemarkets can get rough and tumble at times, with investors sometimes dubbing such periods a ‘bear market’.
But what exactly is one and how you know when the market has been taken over by the ‘bears’?
What is a bear?
Aside than being a carnivorous furry mammal, the term ‘bear’ means something quite different when it comes to finance.
‘Bearish’ investors, or ‘bears’, are those that believe share prices will decline, in contrast to ‘bullish’ investors, or ‘bulls’, who believe shares will rise.
What is a bear market?
By extension, a bear market is one where share prices are actually falling and investors overall are selling more stocks than they are buying.
Put another way, there are more sellers (bears) than buyers (bulls) in the sharemarket and therefore stock prices drop as each seller lowers the price at which they are willing to sell.
Given that a share price is determined by what someone is willing to pay for it, as more people sell a company, the asking price drops in order to find more buyers of it.
Of course, as the price lowers, more investors are reluctant to buy it because suddenly the valuation is sinking while more people begin selling to avoid greater losses. This cycle can compound and the possibility of a bear market arises.
However, that doesn’t mean that afew bad days for shares is a bear market.
Technically, a sharemarket must fall by more than 20 per cent before it can officially be called a bear market.
Consider the most recent plunge on the Australian sharemarket (ASX) for example.
The ASX touched 5467 on the 21 December 2018, down a whopping nearly 900 points from its previous 6352, or around 14 per cent.
“We didn’t quite get there, but on any sort of measure, it felt like a bear market,” managing director of Wheelhouse Investments Alastair MacLeod told Trading Day.
While the term is generally applied to the sharemarket as a whole, it can be used for individual stocks that suffer sustained declines, typically over several months.
Take America’s beloved FAANG stocks which all entered a bear market in November last year, despite the stock market they trade on- the Nasdaq- remaining outside of the classification.
How to spot a bear market
Hindsight might be 20/20 but what are the signs that a bear market is on its way?
Fears that the economy is slowing and a market crash could be imminent are all part of the psychology behind bear markets.
“There’s a lot of similarities as we go into recession on how markets perform and we’ve found that there are three distinct phases the stock market goes through as we move into recession,” MacLeod said.
Consider the chart on the left, which shows how the US share market adjusted during the Global Financial Crisis (GFC) for example.
The first signs of trouble
The first step is nervousness, according to MacLeod.
“If you think back to 2007, the market peaked in September, but from earlier that year, industrial surveys, PMIs started going down, they started rolling over. There was still growth but the growth was slowing,” MacLeod explained.
As economic indications such as wages, spending, and manufacturing began to falter, confidence in the market also began to wane.
“That’s exactly where we are now,” he said.
As the market falters and investors grow increasingly wary, a bear market can become a self-fulfilling prophecy as more and more begin to pre-empt the market and sell.
“When you look at the volatility index, the VIX, at around this period [in 2007] it started to pick up ahead of the banks issue,” MacLeod said.
After significant volatility throughout the October to December period, and a tranche of weaker economic data it does appear as if nervousness is creeping back into the market, according to MacLeod.
“In every recession, markets start de-rating ahead of time because they’re looking forward. It doesn’t mean that just because we get a market de-rating it’s always going to end in a recession but they always start like this,” he explained. “When we look at those indicators, it does feel like that’s where we are today.”
The folly of timing
Believing that a bear market is ahead might see you moving into more defensive stocks, or reduce your exposure to riskier assets.
It doesn’t, however, mean that you should pull all of your money out of the market at the first sign of trouble.
“If you miss the best day of every month or the best day of every year, then your [average] annual return as an equity investor goes from 9 per cent to 3 per cent,” MacLeod said. “That’s the issue of not being invested and trying to time it.”
“It would be nice to have the luxury of [knowing] there’s a recession coming in two years when we’ll move our money into cash, and gold, and baked beans but if you’re in retirement you need money to live on,” he added.
“Equities will give you, or should give you, that return but it’s a bumpy road.”
Watch the full segment above.