What’s it: A bear market refers to a capital market experiencing a period of decline in performance. Bear is a term applied to an investor who is pessimistic about a particular security price prospect. Such a downturn in the market we call “bearish.”
A decline in investor confidence usually signals the start of a bear market. When investors believe something terrible will happen, they will take anticipatory action by selling securities to avoid losses. As a result, selling pressure increased in the market.
In fact, sometimes, the drop can be as high as 20%. Investor confidence falls, increasing the selling pressure that was even more severe.
Difference between a bear market and a bull market
The opposite of a bear market is a bull market. We call market conditions where investors are confident or optimistic as bullish. Securities prices tend to rise due to widespread investor optimism and encourage them to buy.
Why we call a bear market and a bull market
The term “bear” takes the metaphor of a bear trying to bring down its enemy or prey. The bear will move its paws from up to down, causing the prey to actually fall.
Meanwhile, “bull” takes the metaphor from a bull. To fight, it will attack by thrusting its horns into the air. That is why a market with rising securities prices is called a bull market. To win and make a profit, investors continue to buy securities, hoping that the future price will be higher.
What happens during the bull market and bear market
Bear markets occur when investors become pessimistic about their portfolios. It usually occurs during a deteriorating economy, such as a recession, driving down the stock market. Prices fall, which may occur suddenly or slowly.
Seeing the price decline, investors are hesitant about future prices. They believe that prices are more likely to fall than rising, at least in the near term. Being more skeptical of the stock market’s performance, some investors sold their securities, causing further declines.
The decline creates a spiral of falling prices. Pessimism spread to other investors and increased selling pressure. They massively sell the securities they have, so the price of the securities falls even further. As the losses get bigger, investor confidence decreases further until the stock market crash occurs.
Conversely, in a bull market, securities prices rise due to high investor optimism. It is common during a prosperous economy, which brings brighter prospects for the stock market.
Households have more money to spend as prospects for income and employment improve. That leads to increased sales and business profits.
Higher business profit convinces investors that prices are still potential to rise. The price increase creates greater optimism in the market, prompting them to buy securities. Strong demand causes prices to rise as investors compete to buy and get capital gains.
Causes of the bear market
As I said before, during a bear market, pessimism is widespread among investors. Prices fell deeper due to high selling pressure.
Pessimism arises for several reasons:
- Economic downturn or crisis
- Aggressive economic policy
- Unforeseen events
- Investor psychology
In the stock market, a bear market usually occurs when investors anticipate a decline in economic activity. Take a recession, for example. During this period, the unemployment rate is high, and consumer spending is low. The outlook for household income is deteriorating, leading to lower demand for goods and services and lower business profits. This decline in profit directly affects the share price valuation.
Aggressive economic policy
One source of panic is a drastic increase in interest rates. This may occur because of high debt and the risk of default on government payments.
Also, increases in interest rates may occur during periods of high inflation. To subdue inflation, the central bank raises interest rates. When interest rates rise drastically, economic growth contracts (rather than slows down) as aggregate demand falls significantly.
Finally, the increase in interest rates causes the price of government debt securities to fall. This spread to the corporate debt securities market because they usually use government debt securities as a benchmark.
Take austerity policies as another example. The government runs it to reduce the debt burden and the risk of default. The option is to reduce spending and increase tax revenue. Both weaken aggregate demand and economic growth in the short run.
Say the government chooses to raise taxes high to increase revenue. An increase in taxes causes a decrease in corporate profits, causing share prices to fall.
For example, the COVID-19 pandemic causes economic activity to crash, which triggers investor panic. They immediately reallocate their portfolios to safer assets. They avoid risky assets such as assets in developing countries and stocks in the transportation, tourism, and trade sectors.
In Indonesia, for example, COVID-19 causes foreigners to leave. It causes a fall in the government debt securities market and the stock market. From January 20 to March 30, 2020, capital outflows reached IDR167.9 trillion, consisting of IDR153.4 trillion in the government debt market and IDR13.4 trillion in the stock market.
Psychology affects how investors react and make buying or selling decisions. A sell-off by some large investors could trigger panic by other investors and cause further market shocks.
Bear market trading strategies
Bear market and bull market are common phenomena in the stock market. Although we often associate it with the stock market, the bear market also applies to the bond market. Therefore, to deal with it, we also need a different approach.
In this section, I’ll go over the specifics for the stock market. There are several options for dealing with bears.
Chasing defensive stocks
Some defensive sectors, such as utilities, are usually less susceptible to economic weakness. Defensive firms perform well and are relatively stable during the highs and lows of the business cycle.
Because they have stable cash flows, they provide consistent dividends and stable profitability even during a market downturn. Therefore, even though they do not book capital gains, investors still generate income from dividends.
Reallocating investment to safer instruments
Bear markets usually occur during difficult economic times where economic activity is falling. Businesses are cutting their output due to weak demand. To get out of this condition, the central bank will usually lower interest rates to stimulate growth.
Investors will usually shift their investment to safer instruments such as gold and bonds. In particular, an interest rate cut works in reverse with bond prices. So, if the central bank lowers the policy rate to stimulate economic growth, bond prices should go up.
Say, an investor has a bond with a 5% coupon, and the interest rate drops from 5% to 4%. The coupon rate for bonds will now appear more attractive to investors so that they are willing to buy more.
Because they are pessimistic about the market’s direction, investors use various counter techniques, namely taking profits when the market falls and losing money when it goes up. One of the most common techniques is short selling. This technique represents the opposite of conventional investing (buy low and sell high).
To illustrate this, I will take a simple example. An investor borrows shares from a broker to sell (for example, at IDR500). After receiving the proceeds from the sale, he still owes the broker the number of shares borrowed.
As prices tend to fall, the investor closes the short-selling by buying at a lower price (for example, IDR400) and returning the borrowed shares to the broker. The difference between the selling price (IDR500) and the buying price (IDR400) is the investor’s advantage. If he borrows 1 lot (100 shares), the investor gets a profit of IDR10,000 (100xIDR100).
Holds more cash
Investors will usually increase cash on hand just in case. They place it in several safe havens such as the US Dollar and Euro, thereby reducing the risk exposure to the downside.
Focus on the long term
Bear markets usually last in the short term. And, in the long term, the stock market shows an upward trend.
In the United States, the bearish average occurred once every 3.6 years since 1900. Meanwhile, the bearish average lasted for 13 months, with an average decline of -13.2% to -30.4% from 1946-2018. Then, the market recovered again in 3.7-21.9 months.
In anticipation of the downturn, some investors focus on long-term strategies. They choose companies with strong fundamentals and have a competitive advantage. During difficult periods, the company still has a solid balance sheet to maintain its long-term performance.