What is a bear market. How should you trade or invest in one

There are 2 ways to define a “bear market market” vs a “bull market”.

  1. A state of mind (investors’ psychology)
  2. A quantitative method.

In terms of investor psychology, a bear market is “prolonged period of falling market prices in which the downwards decline becomes a self-fulfilling prophecy”. This means that there is widespread pessimism among investors and traders. Investors/traders sell because they expect prices to fall. Prices fall, so investors/traders expect prices to fall even more. They sell, then prices fall even more. It’s a vicious cycle.
This means that the market’s medium-long term trend is going down even though there may be bear market rallies along the way. Bear markets are characterized by:

  1. General investor pessimism (expectations that the market will fall in the medium-long term).
  2. Negative or deteriorating fundamentals. Each market’s “fundamentals” are different. For example, the stock market’s fundamentals are the economy and corporate earnings. The economy deteriorates in an equities bear market.

The key phrase here is that prices are trending lower in a bear market. But how do you define this concisely? How much do prices need to fall for it to be a bear market? How long do prices need to go down for? A TIME definition is just as important as a MAGNITUDE definition.
That’s where the quantitative method comes in. The generally accepted definition of a “bear market” is a decrease of 20% or more for the stock market that lasts at least 2 months from top to bottom.
*Other markets define this differently. For a highly volatile market like silver, a 20% decline is merely a “correction” and not a bear market. The stock market is less volatile than commodities.

Problem with the standard definition of a bear market

I don’t like it when the conventional wisdom defines a “bear market” as a 20% decrease in prices.
Why 20%? Why not 21% Why not 19%? Why not 18%? Why not 25%?
This is a silly technicality that many investors and traders seem to get caught up in. They consider the 2011 stock market decline to be just a correction because the S&P fell 19.3% when you use the CLOSE prices. But the S&P fell 21% when you use the HIGH and LOW prices. They don’t consider this a “bear market” on the mere account of 0.7%.

20% was an arbitrary figure picked out of Stock Traders Almanac more than half a century ago. It became widely accepted simply because it was one of the first definitions.
What we’ve noticed is that 20% is not the accurate way to define a bear market. A bear market is “marked by widespread pessimism that feeds on itself. This leads to wave after wave of selling. This generally does not happen during 20% declines. 20% declines generally see 1 crash and a retest. Nothing more.
That’s why the Medium-Long Term Model considers 20% declines to be “significant corrections”.

How we define the term “bear market”

We have to go back to the psychological definition of a bear market: “widespread pessimism that feeds on itself” (i.e. wave after wave of selling). When the Medium-Long Term Model quantifies this state of mind….

Bear markets are 40%+ declines that last at least 1 year (from top to bottom).

This means that bear markets are much rarer than mainstream media would have you believe. There have only been 6 bear markets since the Great Depression.

  1. 1929-1933
  2. 1937-1938
  3. 1968-1970
  4. 1973-1974
  5. 2000-2002
  6. 2007-2009

All of these bear market saw wave after wave of selling. TIME (at least 1 year) is just as important as MAGNITUDE (40%+ decline) because TIME causes widespread pessimism. If the stock market crashed 40% in one day and then rebounded to new all time highs over the next 3 weeks, there would be no widespread pessimism. It’s  prolonged downtrends that make investors lose hope of a quick recovery.
There were many 15%, 20%, and even 25% declines during these bull markets. These are called “significant corrections” according to our Medium-Long Term Model.

How should you invest or trade a bear market

The Medium-Long Term Model (my strategy) states that I should just stay in cash during a bear market. This is the point that many traders and investors don’t understand:

You don’t always need to be trading and making money. Sometimes being in cash IS making money.

When it’s a bear market, everyone around you is losing their shirt, and you’re in cash, you are relatively better off! All you need to do is buy back into the market at the bottom of the bear market.
The market’s initial post-bear market snapback (i.e. first leg of the new bull market) is always extremely fierce. A 2x of 3x leveraged ETF compounds like crazy in the first leg of a bull market. That yields massive profits.
Buy short term government bonds
You can also consider buying a short term Treasury bond (e.g. a 2 year bond) when you think a bear market is imminent. Bear markets typically last 1-2 years, so that Treasury bond will mature by the end of the bear market. You can use the proceeds to buy stocks at the bottom of the bear market.
It’s nice to make e.g. 2% a year when the stock market is crashing 40%+
Short the bear market
Shorting the bear market is one way to trade profitably. But here’s the key point that traders should remember: never short the market when it’s going up. Don’t try to predict the top in advance. Short the market on the way down.
The bull market might last a little longer than you think. Let’s assume that you think the bull market has 1 year left. You wait 10 months and then you short, expecting the bull market to end in 2 months.
What happens if you’re wrong? What happens if the bull market has 2 years left? The market can go up a lot in the final 2 years of a bull market. You will lose a lot of money on your short position.
Never underestimate humanity’s ability to be optimistic. The best fund managers were long term bearish on the stock market by 1998 (e.g. Jim Rogers, Julian Robertson, George Soros, Jeremy Grantham). The bull market continued for another 1.5 years.
People were calling Bitcoin’s top at $2k. The bubble continued until $20k. Once again, never underestimate humanity’s ability to be optimistic in a bubble, regardless of whether that optimism is supported by solid fundamentals.
It’s one thing to miss out on the last 1-2 years of a bull market. It’s another thing to lose money shorting while everyone else is making money by being long in the last 1-2 years of a bull market.
You must wait until it is very clear that the bear market has started before you short. A short position in a rising market faces the risk of a margin call. That’s why you want to short the market on the way down.
It’s very easy to know when the equities bear market has started. It’s not guaranteed that the bear market has started when the economy is just deteriorating. But it’s guaranteed that a bear market has started when the economy tips into a recession. Recessions typically start 1/4 – 1/3 of the way into an equities bear market.
What not to do
You should never trade the news in the first place. This is true in bull markets and is especially true during bear markets. The market, macro environment, and political news moves quickly during a bear market. The economy is rapidly deteriorating, the market’s volatility is crazy, and governments are rapid-firing their policy clips in order to stop the bear market.
News tends to fly all over the place during a bear market. This happened in the second half of 2008. In the morning the government would come out with a “bullish policy” and the stock market would spike 5%. In the afternoon the government would come out with a “bearish policy” and the stock market would crater 5%. Daily and intraday volatility were insane.
Anyone who traded by following the news would have been whipsawed back and forth. That whipsaw would have resulted in a lot of losses that added up over time.
You need to have a well defined plan in a bear market and stick to it. Don’t deviate from your plan just because of the news. You never know what the next piece of news or government policy will be.
Don’t catch the falling knife in a bear market
Some traders like to predict bear market rallies. This is dangerous. No 2 bear markets are alike. Some bear markets drop like a stone but have large rallies, while other bear markets don’t have large rallies at all.

Don’t go long in a bear market until you think the bear market is over. Don’t trade bear market rallies. You have no idea when the rally will start and you have no idea when the rally will end.

6 comments add yours

  1. Hi Troy,
    Another great article mate. Once again thanks for your thoughts – they are much appreciated. Meanwhile I have a suggestion for your next piece – an article on “Significant Corrections”! 😉

  2. Hello Troy,
    Thank you very much for an informative article.
    It is my good luck that I had come across a blog like yours.
    May GOD bless you, for sharing your thoughts without expecting anything from your readers.
    With Regards,

  3. Hello Troy,
    I made a spreadsheet to go through the S&P 500 and market the bear markets the way you did here, to make sure I understand your definition of a bear market. I’m having an issue though in that my dates don’t match yours exactly.
    Specifically, I see an additional bear market from November 10, 1938 to April 28, 1942, which dropped from $13.79 to $7.47 (46% in more than 1 year).
    Also I’m not seeing the bear market from 1968 to 1970. I show a high on November 29, 1968 of $108.37 to a low of $69.29 on May 26, 1970, which although it comes close is only a 36% decline.
    I’m wondering if you are using a different index than the S&P 500 for this or if I’m misunderstanding your definition? Thanks.

    • LOW on May 26 1970 = $68.61
      HIGH on December 2, 1968 = $109.37
      Bear market was from 1937-1942. That was a complete one.

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