Bear

What Is A Bear Market?

A bear market is characterized by a sustained decline of 20% or more in market value from recent highs, driven by widespread pessimism and a higher volume of sellers than buyers.

Bears are market participants with a negative outlook. They act on their beliefs by selling shares they own at perceived high points or by using derivatives to hedge against market downturns.

The term "bear" originates from the bear's attacking style, swiping its claws downward, mirroring the market's downward movement during bearish sentiment. In contrast, bulls push upwards, reflecting a rising market in bullish sentiment.

Understanding Bear Market Dynamics

A bear market is established when there are more sellers than buyers, leading to a decrease in market value. A fall of 20% or more in market value from the most recent high is an institutionalized arbitrary depiction of when we have entered such a market.

A different interpretation is the movement of investors from riskier assets, in equity, to more secure investments, such as treasury bonds.

Although treasury bonds are considered the safest investment option, as the US government backs them, they provide relatively low yields compared to emerging equity investments.

The 2020 coronavirus pandemic forced the government to respond to the forecasted weakening economy, providing stimulus relief and quantitative easing (QE). 

The Treasury Bond market was isolated by the government’s QE program introducing a flood of new money. This stimulated the economy, promoting riskier asset investments like cryptocurrencies. 

This market may be followed by a recession depending on the severity of economic or political circumstances. 

A recession is two consecutive quarters of negative gross domestic product (GDP). GDP factors in consumer spending, government spending, investments, and net exports.

Unfavorable conditions cause them to emerge, believing economic performance will be negatively impacted.

In the time leading up to a possible recession, stocks often trade at lower multiples, preemptive of economic or financial turmoil. These repercussions are factored into the market by selling stock considered overvalued during a crisis.

Events that may initiate this market include weak economic output, pandemics, fiscal policies, geopolitical crises, wars, sanctions, market bubbles, trade agreements, and many other detrimental factors.

They generally influence lower employment, productivity levels, disposable income, and business profits, all indicators of a poor time to invest in stocks.

Stages of a Bear Market

These markets can persist for months to years. The shorter-term market is referred to as cyclical, occurring more frequently. Alternatively, secular (long-term) bear markets can last for decades due to monumental financial events but occur less frequently than cyclical downturns.

Secular markets may rally between periods. However, there is no sustained growth able to reverse the call.

The sequence of a bear market is as follows:

1. Initially, bullish sentiment is high, causing stock valuations to rise rapidly.
2. This can create overestimations of a company’s or stock’s intrinsic value, meaning traders would maximize their profit by selling at this perceived peak.
3. Stock prices begin to dive and consolidate at reference points, testing market sentiment.
4. Economic indicators may start looking gloomy, maybe from a market bubble that’s been growing.
5. Prices start to fall dramatically as the turmoil becomes more visible, with panicked investors selling to secure their wealth, even if it may return a loss, in capitulation.
6. Speculators enter the market at lower prices to acquire cheaper shares. However, they enter at various points, causing further consolidation to identify a trough.
7. Eventually, the bullish market sentiment returns, and investors are attracted to the low stock prices.

A market correction should not be confused with a bear market. Instead, a correction is a downtrend influenced by a stock being perceived as overvalued. 

Therefore, stocks were sold at a higher price and returned at a lower price. As a result, traders can more easily find a new entry price after a correction.

Price can drift between support and resistance lines, allowing for technical analysis of the general market value range.

A correction can transform into a bear market if circumstances worsen, such as a forecast displaying a reduction in growth or unpopular changes to the current business model.

Unlike during corrections, entry points within this market are much harder to calculate, as the bottom is less foreseeable.

Bear Market and The 2008 Financial Crisis

A growing housing bubble caused this crisis when it eventually burst in 2007. Mortgages and loans were actively credited to subprime borrowers with no conventional repayment method.

Instead, the house bought using a mortgage appreciated over time, allowing the homeowners to eventually sell it to pay back the mortgage and make a profit. 

Financial institutions were capitalizing on mortgage-backed securities (MBS) and collateralized debt obligations (CDO), placing the financial pressure of risky bonds in the hands of regular investors and some large banks looking for a greater return on investment.

These securities were at the mercy of the housing market.

Eventually, interest rates rose, and the growth in the housing market began to slow. A wave of defaults left investors with significant losses, and the houses used as collateral were priced lower than the original mortgage, leaving owners unable to recoup their investments.

This spread worldwide, impacting the global financial market and requiring the government to bail out some of the biggest financial institutions, impose new financial regulations, and introduce monetary policies to stimulate recovery. 

Consumer confidence was at an all-time low and had cascading effects as an exodus of investors withdrew their funds, initiating such a market for approximately 17 months.

The S&P 500 peaked at 1,565.15 points on October 9, 2007, and had plummeted to 682.55 by March 5, 2009.

Bear Market and The 2020 Coronavirus Pandemic

A sudden bear market emerged in February 2020 after Coronavirus had been classified as a global pandemic. As a result, new safety measures were imposed to prevent the virus from transmitting and spreading throughout the planet’s population.

People were isolated in their houses, an unprecedented experience for most. This affected many businesses that relied on personal interactions.

The S&P 500 reduced to 2187.8 from recent highs of 3400, a downward movement of roughly 35%. However, government stimulus and quantitative easing measures injected money into the economy, providing financial aid and preventing economic contraction.

After introducing these new measures, markets rebounded, ultimately hitting new all-time highs due to the increased liquidity.

However, post-pandemic, the extensive measures to prevent a recession during the pandemic have dramatically increased the global supply of money.

Inflation has soared past the central bank’s 2% target rate, almost reaching double digits, causing the purchasing power of many currencies to decrease.

Central banks have acted by hiking interest rates, making debt more costly, thereby reducing the rate at which the money supply grows.

Simultaneously, supply constraints from the pandemic and Russia's invasion of Ukraine have increased the cost of crucial commodities such as fuel, adding to inflation.

Businesses are anticipated to struggle under these economic conditions, and investors fear an uncertain future.

Precautions to Take under Bearish Market

If such a market emerges, we are most likely heading into a recession, the economy will slow, and unemployment may rise. 

You may need to adopt a few precautionary measures to ensure you are financially secure during these uncertain times.

For example, accruing enough funds for at least six months' worth of living expenses in case of potential work layoffs.

1. High-interest debt: Avoid high-interest debt as interest rates could rise, further increasing the costs.
2. Limit your expenses: Increased discretionary spending won’t help make debt repayments. Therefore, you should only buy essential items. 
3. Wage increase: If the inflation rate is high, you might consider negotiating a pay rise with your employer to ensure your wage is consistent. However, be aware that an increase in payroll contributes to inflation.
4. Diversified investment portfolio: The wider your range of sensible investments, the less impactful a bear market may feel compared to a portfolio of capital concentrated in a single risky asset.
5. Dollar-cost averaging: Although the market may be declining, smaller regular investments every month instead of a single larger investment once a year may secure a lower average stock price in anticipation of a market rebound.
6. Avoid risky assets: Emerging markets, such as cryptocurrencies, are more volatile due to lower liquidity and less security during economic unrest. Hence, you can experience more dramatic losses.

Shorting And Bear Market

Short positions are held when a trader expects the market to decline. It is a strategy used to gain capital from a declining market. Therefore, entering a short position can be very profitable before a bear market emerges.

Short positions can be naked or covered. A "naked short" refers to selling a security without owning it or borrowing it from a third party. This method of shorting is illegal in the US.

A “covered short,” the more common variant of the two, refers to temporarily borrowing stock from a stock loan agency, where the recipient must pay monthly premiums to possess the stock. 

During this period, the trader would sell the stock at its highest price, expecting a return from a drop in its value. Then, they would have to buy the same amount of stock back from the market, hopefully at a lower price, to give back to the loaning agency.

The difference between the value the shares were sold at and the price they were bought back at equates to the return on the short position (excluding the fees for trading and borrowing).

Shorting comes with more risks than buying stock, as, when buying stock, the most you can lose is all the money you have invested. This occurs when the company crashes, and the stock is valued at nothing, zero.

On the other hand, shorting has an infinite loss potential, as the stock price can continue breaking records if the company exceeds expectations. This can create an event known as a "short squeeze."

A short squeeze is where a short trader is pinched by increasing buyers, leading to the stock price rising. 

The higher the share price rises, the more margin is required to keep the position open. If the investor runs out of cash to put into the account as a margin, they may be forced to liquidate other positions in the account or the short position itself. 

To prevent a dramatic loss, the trader can repurchase the stock, which can cause the market to surge, depending on if the volume of stock purchased is large, commonly seen among institutional traders.

Put options

Put options are alternative derivative contract securities that can be profitable during this market.

A derivative’s value is based on the underlying asset’s characteristics (price, volatility, etc.). Put options enable investors to hedge risks that may devalue the return of their underlying long-term investments.

Put options contracts give the option buyer the privilege to sell shares (usually 100) at a predetermined price, known as the strike price, before a set expiration date.

The price paid for this contract is known as the premium, which factors in:

• Extrinsic value - The value of the contract in relation to the underlying asset, i.e., the difference between the strike and market price
• Intrinsic value - The value of more esoteric traits, like implied volatility. The variables that describe the inherent value of an option are known as the “option Greeks.”
• Time value - The time available before expiration. Less time before expiration decreases the contract’s value as it is less likely to experience a significant price rise.

Options are a less risky hedging strategy than short selling. You are not forced to exercise an option, limiting loss to the premium paid.

Inverse ETF

Inverse exchange-traded funds (ETFs) are constructed using derivatives to profit from a decline in the value of the underlying asset, similar to short selling.

The difference between inverse ETFs and short selling is that ETFs do not require a margin account for transacting loans. As a result, the fees for holding a loan can be more costly when short selling, diminishing overall returns.

ETFs may only charge an expense ratio for their services using a single brokerage account, making it less costly to investors.

Inverse ETFs allow retail investors to be more involved in downside trading. They can bet against a single stock or index ETFs without the hassle of securing a loan of shares and managing other peripheral duties.

Leveraged ETFs allow a return on investment to be multiplied by using borrowed finance to increase the margin of trade. It can extend your profits beyond your invested capital and intensify your losses, so be sure to complete your due diligence. 

Conclusion

A persistent 20% or greater drop in market value from recent highs, caused by a glut of sellers relative to buyers and general pessimism, is referred to as a bear market.

To contribute to the market's decline, bears or pessimistic investors sell shares at perceived peaks or use derivatives as hedging. This attitude runs counter to optimistic markets, where prices increase.

Regarding the economy, bear markets frequently result in recessions marked by several quarters of negative GDP growth. These recessions cause drops in corporate earnings, employment, productivity, and disposable income, which presents difficulties for investors.

Instances such as the financial crisis of 2008 and the COVID-19 pandemic of 2020 demonstrate that significant economic downturns necessitate significant government action. 

Bear markets begin with extreme optimism and inflated stock prices and move through stages. Stock prices decline as overestimations are adjusted, gauging the market's mood.

As economic indicators deteriorate, substantial price losses and panic selling occur. Eventually, traders enter the market at reduced prices, which could result in consolidation and a comeback.

Investors can successfully traverse bad markets through the use of diversified portfolios, put options, and short selling. A solid understanding of bear market characteristics helps you make wise decisions, protect your investments, and maintain financial stability.

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