The Anatomy of a Bear Market
Bear markets, everyone has heard of them – now everyone is talking about them. A bear market is defined as a 20 percent or more decline in an index peak to trough. Bear markets may be accompanied by a recession, but since the base definition of the market phenomenon is a decline in the asset or index in question, many times a recession-less bear market can occur. Bear markets are common in asset markets and normally they are relatively brief. However, their structure is worth studying because the increased volatility during their duration can cause greedy or fearful investors to make detrimental decisions.
The depth of a bear market is the primary concern for investors and their portfolios. As the Old Wall Street adage states, “no matter how low it goes, no matter how bad it gets, it can always go down another 100 percent.” While it may seem that another 100 percent decline for a portfolio is in the cards; the typical bear market has an average decline of roughly 36 percent. The largest bear market recorded was the September 1929 to June 1932 decline. This bust began what is known as the Great Depression. From peak to trough a rough estimate of the index at the time was down a terrifying 86 percent. This bear market lasted 33 months. The second largest from the sampling of 23 bear markets since 1928 was the great financial crisis in 2008. This bear market had a decline of 58% from October 2007 to March 2009 and lasted 17 months. A general rule of thumb for bear markets is that those bear markets that are accompanied by an economic slowdown tend to be more veracious in length and scope.
The average duration for a bear market is approximately 12-14 months. This can give investors solace that brighter days are on the horizon and approach relatively quickly. However, the longest bear market recorded was the November 1938- April 1942 bear market that lasted 36 months - a three-year decline! Bear markets in general can be divided into three sections. The first third of the bear market, investors barely realize that it has begun as equity losses are relatively moderate. An index may hover down 5% or so for 3-5 months. The second third is slightly more volatile with losses that continue to accrue. The final salvo of a bear market is the worst with the majority of decline occurring in the final third. Bear markets have been known to have aggressive rallies. In 2008 the bear market provided 24 percent, 18 percent and 12 percent rallies that gave bullish proponents false hope that the worst of the cycle was over.
How should investor prepare for a bear market? Bear markets very quickly expose the importance of equity valuation and cash flow for assets owned. Great companies can be bought at less than ideal prices especially at the peak of a raging bull market. Investors should shift their assets to quality holdings that have tenured management, many times these types of companies with strong balance sheets will end up with less competitors and more market share after a lengthened economic rout. Is it possible to correctly time bear markets? It has been done- however it is incredibly risky. Bear markets create increased volatility in asset prices and speculators that move to cash in an attempt to foray losses may in fact cause a permanent impairment of capital as prices can rebound from lows quite aggressively. The majority of patient investors make money in a bear market especially if they are systematically adding capital to risk assets in their accounts. A proper portfolio should be constructed in such a way that investors are not “forced” to make any decisions to continue to fund their retirement or goals.