What Is a Bear Market?
The simplest answer to what is a bear market is that it is a market showing a lack of confidence. It is an extended period in which stock prices drop across the market. Major indices such as the Dow and S&P 500 also fall, and trading volume can initially stagnate and then sharply decline.
To quantify what is a bear market, a price decline of 20% or more generally signals that we have entered a bear market. The accepted length of time before a drop in prices signals entry to bear market conditions is two months.
If the period of declining prices is less than two months, and is immediately followed by a period where stock prices rise, the phase is not recognized as a bear market but rather, as a ‘correction.’
A market correction is a temporary reversal of the current trend in price movement of the market. ‘Correction’ is often used to describe a brief decline after a period of rising prices. A correction can often be beneficial for the long term health of the market if prices had been rising too sharply. The correction lowers prices to more realistic levels where investors again perceive attractive value. This results in newly increased trading volumes which restore the upward trend.
This is not always the case though and usually if the government goes into recession and the inflation rate is high, the downward trend will continue.
Past the two-month mark, declining prices signal entry into what is a bear market, and this brings widespread pessimism and lack of investor confidence. Decreased liquidity can create a scenario in which everyone is selling their stocks and the prices of stocks come crashing down.
Bear markets usually occur when the economy is in a recession and unemployment is high, or when inflation is rising quickly. The most famous bear market in U.S. history was the Great Depression of the 1930s. The recent financial crisis is also a prime example of what is a bear market, and is certain to go down in history as a significant world-wide bear market.
Investors who attempt to profit from declining prices are referred to as bears or as being bearish. While a bear expects the market overall to decline, an investor who thinks that a particular stock or commodity will drop is known as a pig.
It is likely that the term ‘bear’ originated from the business practices of bearskin salesmen back in the 1700s. Historically, these salesmen would sell skins they had yet to receive. As such, they would speculate on the future purchase price of these skins from the trappers, hoping they would drop. If the prices did drop, then the salesmen would profit from the difference between the cost price and the selling price.
One method of profiting in a bear market is by short selling. Short selling is very similar to the practice used by the bearskin salesmen. In effect an investor is selling shares in a stock that they do not actually own. The shares are ‘loaned’ to them by a broker, and then sold to the buyer. The proceeds of the sale go to the investor, who then, at some point, has to return the same number of shares to the broker to repay the loan, or ‘close the short.’
If the prices continue to drop as the investor has expected, and they buy back the shares at a lower price, the profit is made in the difference between the initial sale price they received, and the purchase price they must pay to return the shares. The risk is that the price could rise, in which case the investor makes a loss by paying more than they received to buy back the shares.
Another way to profit during a bear cycle is by purchasing put options. The profit made on put options is in direct proportion to the decrease of the underlying stock price.
The third method of making money during a market downturn is by recognizing the market bottom, or lowest point in the cycle, and buying shares at a low price that you will then be able to sell at a high point in the following bull market phase. The drawback is that it is very difficult to pick the lowest point. There can often be a ‘false bottom,’ which means that a seeming low point is followed by a brief rallying of prices, and then continues to decline further.
This is a general overview of what is a bear market, what causes these downturns, and who profits from bear cycles.
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