What’s a Bear Market? Here’s 7 ways to detect them and avoid big losses

It is easy to forget there is such a thing as a bear market during long-run stock booms, but the threat always lingers. In fact, what makes market downturns damaging is that they occur after prolonged upturns and many who bought stocks will lose money on them.

Understanding bear markets is crucial for investors to navigate periods of market decline effectively, manage risk, and capitalise on potential recovery opportunities. Therefore, we’ve written this guide to help investors understand them, and potentially predict them before they happen.

 

What is a bear market?

A bear market is a financial term that describes a prolonged period of declining asset prices, typically by 20% or more from recent highs. It is important to note that bear markets can occur in any asset class, including stocks, bonds, commodities, and real estate; although we are only talking about stocks here.

Beyond the decline in asset prices, there is low investor confidence and a general sense of pessimism about the future of the market.  Bear markets often coincide with economic downturns, such as recessions, where indicators like GDP, employment rates, and consumer spending show negative trends.

 

What causes bear markets?

Several things can. Most investors would recognise that geopolitical events – wars, political instability and pandemics – can create uncertainty and lead to market declines. When the COVID pandemic first hit, markets fell nearly 40% from peak to through in barely 5 weeks.

But other things can too. As we hinted above, market bubbles can burst and this can cause a bear market. Adverse economic conditions can play a part. A decrease in economic activity, such as lower consumer spending or reduced business investment, can lead to declining corporate profits and lower stock prices. Finally, we note high inflation and an inability to get inflation under control can cause bearish markets.

 

How to predict a bear market

Predicting the direction of the market, particularly when headed downwards, is challenging because it involves anticipating a significant decline in asset prices before it happens. However, there are several indicators and signals that investors and analysts use to assess the likelihood of an impending bear market. Here are some key methods and indicators:

1. Recession Indicators: Economic slowdowns or recessions often precede bear markets. Key indicators include declining GDP growth, rising unemployment rates, and decreasing consumer spending.

2. Inverted Yield Curve: Historically, an inverted yield curve (when short-term interest rates are higher than long-term rates) has been a reliable predictor of recessions and subsequent bear markets.

3. Interest Rate Hikes: Central banks (like the RBA) raising interest rates to combat inflation can increase borrowing costs, reduce consumer spending, and slow economic growth, potentially leading to a bear market.

4. Investor Sentiment: Surveys of investor sentiment, such as the AAII Investor Sentiment Survey, can provide insights into market psychology. Extreme levels of optimism or pessimism can signal potential market reversals.

5. Volatility Index (VIX): Often referred to as the “fear gauge,” the VIX measures market volatility. A rising VIX can indicate increased investor fear and potential market declines.

6. Moving Averages: Monitoring the relationship between short-term and long-term moving averages (e.g., the 50-day and 200-day moving averages) can provide signals. A “death cross,” where the short-term average falls below the long-term average, can indicate a potential bear market.

7. MACD (Moving Average Convergence Divergence): The MACD indicator tracks the relationship between two moving averages. A bearish crossover (when the MACD line crosses below the signal line) can signal potential market declines.

What about geopolitical events, you may ask? Well, that would be worth an entire analysis in and of itself. The reason geopolitical events can cause bear markets is because they were unexpected.

 

How to avoid losses in a bear market?

While predicting bear markets with certainty is impossible, maintaining a vigilant approach at all economic times can help investors identify warning signs and take appropriate actions to protect their investments. Maintaining a diversified portfolio can also reduce risk and provide a buffer against market downturns. As well as this, owning stocks in sectors resilient to economic downturns, like consumer staples, can reduce risk too. No, you may not be able to completely avoid an impact, but such companies may not decline as much as those in other sectors.

 

How long do bear markets last for?

There’s no hard and fast rule here. Some last for months, for instance during the GFC and Great Depression. Others, such as the Corona Crash, are very short in duration. There is also debate as to exactly when to define the end of a bear market? Is it when prices start to rebound, or is it when prices reach their pre-bear market highs?

 

Beware of a bear market rally

Investors may confuse the end of a bear market with a bear market rally. The latter is is a short-term increase in the stock market after a period of downward price movement. This is marked by an overall decrease in prices, but with some stocks or sectors experiencing an increase in value due to investor interest. The market will resume its decline once the rally ends.

Bear market rallies are not uncommon occurrences. Indeed, bearish markets are considered to be more volatile and unpredictable than bull markets, making it especially difficult for investors to make long-term strategies due to their short-lasting nature.

 

Conclusion

Bear markets are obviously not a good thing because investors lose money and potentially confidence in their investing capabilities.

But, as easy as it is to forget amidst the despair of it all, is that market downturns do not last forever, and can provide the opportunity for patient investors to buy stocks that can make hefty gains in the long-term. There are also ways to detect bearish markets before they happen, even though they are difficult. So even if you are too scared to dip your toe into the water in the middle of a market downturn, you may be able to get out before the worst of it hits.

 

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