The words themselves sound ominous – if not frightening: “bear market”.
The S&P 500 entered a bear market in June, marking a 20% drop from the January peak.
Bear markets often coincide with fear and uncertainty about financial markets in general. But what does history tell us about their duration and how far markets can fall? And how should you treat your investments during a bear market?
What is a bear market?
According to the Securities and Exchange Commission (SEC), a bear market occurs when an individual stock, index (such as the S&P 500), or entire asset class declines in price by at least 20% for at least two month.
Note that everyone else is equally strict on the two-month deadline, but this is an extended price drop of at least 20%.
Often, but not always, a bear market indicates an upcoming recession. Bear markets go hand in hand with negative investor sentiment. This includes pessimism and even panic.
Usually companies make less money. Expectations of future earnings are declining. Media companies are starting to write stories about people who have been financially ruined and about individual stocks whose price has dropped dramatically.
It can feel like things are only going to get worse.
The number 20% is not materially significant. It is just an imaginary boundary that helps to track and understand market performance. We also call a drop between 10 and 19.9% a “correction”.
No two bear markets are the same. But history can help us understand what to expect.
How long do bear markets last?
The S&P 500 became an entity in 1957. However, we have historical records for the performance of America’s 500 largest companies dating back to 1928.
There have been 27 bear markets since 1928, including this year’s, according to Hartford Funds. The average bear market lasted 289 days – or about 9.5 months – with an average decline of 36%. (The longest, which spanned from 1973 to 1974, lasted 630 days, or just under 21 months.)
Prior to World War II, the S&P 500 entered bearish territory once every 1.4 years. Since then, we only see bears come out every 5.4 years.
The worst bear market saw the S&P 500 fall 61.8% in 1931-32 during the Great Depression. Unfortunately, this was one of many significant market downturns over a period of about a decade.
The toughest bear market of my life came during the financial crisis, evidenced by a 51.9% decline between October 9, 2007 and November 20, 2008.
Is it a good idea to buy during a bear market?
Now that you know what a bear market is, you might be thinking of a popular investing trope: buy low, sell high.
The bad news? It is virtually impossible to predict and time the top and bottom of the market.
The good news? You don’t need to time the market perfectly to profit from it.
First, know that financial expert Clark Howard believes investing for retirement should be your financial priority after taking care of your day-to-day needs. He thinks you should spend less than you earn. This way, you can spend years spending part of your salary on your investments for decades.
Clark doesn’t think you should change your investment strategy whether the market is in bearish or bullish territory. (A bull market occurs when market prices rise, usually over a period of months or years. The average bull market since World War II lasted 991 days and resulted in a 114% rise in the S&P 500.)
Just because the S&P 500, NASDAQ or another index has fallen at least 20% doesn’t mean it won’t continue lower. However, more than 80% of the S&P 500’s best days over the past 20 years have occurred during a bear market or within the first two months of a new bull market.
Three ways to invest in a bear market
There are three ways to invest during a bear market:
- Average cost in dollars. Rather than putting all your money into the market all at once just because it entered bearish territory, consider putting an equal amount every month or every paycheck. You reduce your cost basis – or the average price at which you entered the market – by continuously buying during a bear market. And you won’t have to worry about timing it perfectly. Because you will slowly and steadily accumulate a bigger position.
- Diversify your portfolio. You don’t have to wait for a market downturn to diversify. Plus, if you invest in a target date fund — Clark’s most common investment recommendation — you’ll get the diversification you need. But a bear market is the perfect time to make sure you’re properly allocated to your goals and timing.
- Focus on the long term. Don’t try to make sudden, drastic moves or change your strategy significantly just because prices are falling.
How to make money during a bear market
There are several ways to profit when the market is down. The most common is what is called shorting a stock. It is essentially a bet on the fall in the stock price.
Selling put options and buying inverse ETFs are other similar options.
All of these strategies are incredibly risky. You can lose the shirt off your back trying to hit these aggressive bets, so it’s generally not advised.
Large market makers often sell stocks short when sentiment is bad and the market is down. And lower prices also force those who invest with leverage to sell at times.
So just be aware that sometimes the price action continues down due to some of these market forces rather than a significant change in the value of the companies.
Why did we reach bear market status in 2022?
Aside from a short-lived bear market at the start of the COVID-19 pandemic, we’ve had one of the longest and most lucrative bull markets in US history.
It all came to an end in January thanks to the confluence of several major factors. In hindsight, it probably should have been obvious that a significant market decline was very possible.
Here are some of the main factors that pushed the NASDAQ, and then the S&P 500, into bearish territory earlier this year:
- Overheated market. Stocks entered the year historically overvalued based on the typical relationship between a company’s actual earnings and share price.
- Inflation. The most recent inflation figure, 8.6%, is the highest we have seen in the United States for over 40 years.
- Rise in interest rates. The Federal Reserve raised interest rates for the first time since 2018. It did so aggressively, raising combined rates by 1.25% in the last two meetings alone, while signaling further rate hikes on the horizon.
- Threat of recession. More and more people suspect that the United States is going into a recession – if we’re not there already.
- Supply and demand. We have seen ongoing supply chain issues due to the pandemic. We have also seen wobbly oversupply of certain items, particularly during unusual or off-season times of the year.
- Russian-Ukrainian conflict. The war in Ukraine has had an impact on gas prices, among other things, contributing to the supply problems created by the pandemic.
Is there a reason to sell during a bear market?
There is at least one major silver lining to a major market downturn, and that is the possibility of reaping tax losses.
The IRS allows you to offset up to $3,000 of taxable income each year by realizing a loss in the stock market.
In other words, let’s say you earn $100,000 in taxable income in 2022. But you bought $10,000 worth of Amazon stock, which you then sold for $7,000 when the market started falling. Because of this loss of $3,000, you can offset part of your taxable income, reducing it to $97,000.
You can also carry forward any realized loss over $3,000 and apply it to your income in future years.
Now, you don’t want to sell all of your long-term investments just to reduce your tax bill, thereby missing out on future market gains. There are rules about when you can redeem shares you sold at a loss for tax purposes.
Collecting tax losses can be tricky. It’s worth hiring an hourly person from the Garrett Planning Network for advice if you don’t have a fiduciary financial advisor.
The other legitimate reason to sell in a bear market? If you need money to put food on the table, pay your bills and meet your basic needs. Ideally, with discipline and careful planning, you can avoid this scenario. But life doesn’t always work out of a perfect script.
The simplest definition of a bear market is when the S&P 500 or NASDAQ declines 20% or more from its most recent high.
Although bear markets have become infrequent since 2009, they are common – and even necessary – for the long-term health of markets. They offer the opportunity to buy at cheaper prices. And they eventually end.
It’s important not to panic even when the media and your peers are pissed off about prices and your nest egg is losing zeros. Investing is a game that has been going on for decades and requires patience and discipline to stick to your plan.