The technical definition of a bear market is a selloff in a market of 20% or more from its recent highs. The real explanation of what a bear market is that it is a state of mind in which participants in a market are more fearful then greedy. They analyze everything through this fearful mindset which results in exaggerated negative reactions as investors try to protect themselves.
Table of Contents:
- Introduction
- Caution Rough Waters Ahead
- Why is this particular bear market occurring?
- Is it good to buy in a bear market?
- Fear vs. Greed
- Conclusion
Introduction:
Investors and traders in the market must continually be aware of market conditions and try to determine how those conditions will affect their efforts to make money in the market. There have been times when bull markets have lasted for such long periods of time that traders start to act like stocks will continue to go up forever. There are times when individual equities or markets sell off on a consistent basis for a period of time. This is called a bear market.
Bear markets characteristics are as follows:
- A generalized sell off of the market
- Usually 20% or more off recent highs
- Average bear market lasts about 9.5 years
Bear markets are a natural part of the market cycle and in some cases can represent major opportunities for astute traders.
We must emphasize the need to be very careful trading and investing in a bear market. This post is an attempt to answer questions investors have about bear markets and how to turn this negative into a positive.
Caution Rough Waters Ahead:
Traders trading in a bear market reminds me of the YouTube Videos I watch where people have unfortunate encounters with dangerous wildlife like bears and moose. These people see the animal and think that because it is currently acting docile that it is OK to approach these creatures. In the end these people always regret that they didn’t use common sense and not get too close to wild dangerous animals.
A bear market is no exception to this. In a true bear market, nothing can be taken for granted or counted upon. You must be nimble and quick and stay away from unnecessary risk. Bear markets are dangerous. You cannot assume a major negative move is not going to happen. You must be on your game at all times.
Why is this particular bear market occurring?
The first question you have to ask when a bear market starts is: why is this happening? Is it just generalized economic slowdown after a period of fast growth? Is it because a sudden spike in inflation? Is it due to a new pandemic? Is it due to political events around the globe? Is it due to the fact that the previous bull market just was too long, and the market just ran out of steam?
It is very important to understand why a bear market is occurring when you formulate your trading strategy. If the bear market is due to something like the global pandemic, your strategy needs to be different than if this is just a normal, healthy bear market selloff. So, make sure you spend time to understand why it is occurring and then ask yourself how your next planned trade will be affected by it. For example, if it is a pandemic and you are planning on investing in Pharmaceutical company involved in producing a vaccine you must be prepared for potential catastrophic downward movement in the event something went wrong.
Is it good to buy in a bear market?
Buying stocks in a bear market can be a very lucrative endeavor. You have to decide on what your strategy is based on the circumstances of the current bear market. If it is a normal bear market correction, then you will want to consider so called defensive stocks. If it is a market drop driven by current events you may want to look at large cap trading stocks that have been driven down by the market sell off. Here is a list of different types of stocks and our take on their place in the bear market playbook:
- Defensive stocks: in a normal bear market sell off, defensive stocks can be a very important tool to the investor. Defensive stocks include utilities; consumer staples and healthcare. These stocks are considered defensive because due to the nature of the business, people must continue to use their products and services. Defensive stocks may still go down with a bear market, but their general proclivity is still to perform well since their earnings and revenues will not be as adversely affected by an economic downturn.
- Dividend stocks: a stock that pays consistent dividends by its very nature is a well performing company. Many people buy these for revenue and cash flow, not to trade for appreciation. This makes them steadier performers when times get tough. In addition, the dividend payments can soften the blow from any depreciation in the stocks share price.
- Large cap stocks: if you are going to trade in a bear market, you have to avoid high flying growth stocks that will sell off up to 80% or more in this touch environment. By switching to large Cap stocks that have a market capitalization of $10B or more, you slow down the process and allow yourself to build positions methodically giving you a much better chance of making money.
- Stocks that are extremely oversold: when trading in a bear market, it really makes sense for you to figure out how much the stock you going to trade has already come down in price. Stocks tend to have maximum limits to how much they move. This applies to the upside as well as the downside. Once a stock has moved a very large percentage, chances are they are going to rally. If you wait and you are patient, you can play off of an “over sold” position and make some nice trades.
- Foreign stocks and ADR’s: many times, the bear market is caused by economic conditions in our country. By searching out stocks that are foreign based companies but trade on US exchanges, some of the market impact is reduced for these stocks.
There is a great article at Kiplinger about defensive stocks. Click here to go to the article.
Fear vs. Greed:
A bear market is a sign that investors have assessed the current market circumstances and determined that there is much more reason to be fearful than to try to be greedy. Fear and greed are the two mindsets that drive the market. However, as traders we need to adopt the mindset (as we have mentioned in other posts) that Warren Buffet has which is “be fearful when others are greedy and greedy when others are fearful. Click here to see a great article on how this mindset helped people get through the Covid Pandemic Sell off. That mindset makes a bear market the best time to be building positions in the right stocks. As mentioned earlier in this post, we do have to be extremely careful when we do this.
Conclusion
In this post we have discussed what a bear market is, why you have to be extremely careful trading in a bear market, why bear markets occur and the types of stocks you should consider trading in bear market conditions.
Key Points to Remember
- Bear markets can be very treacherous to trade in
- Bear markets can be very lucrative to trade in
- You must figure out the reason for the current bear market and formulate your trading plan with this knowledge in mind
- There are several different market segments that tend to be better for traders in a bear market
- In a bear market, fear overrides greed resulting in exaggerated downward reactions by investors.