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Key Takeaways
- Bear markets are defined by a 20% drop in stock prices.
- The average length of a bear market is typically nine months.
- Investors can use dollar cost averaging during bear markets to boost their overall returns.
Is it bear season? The stock market has been on a roller coaster ride lately, and many investors have differing opinions on where the market is going next. Some are predicting the next crash. Others expect inflation to cool and the stock market to rise.
You're not alone if you're feeling nervous about investing in today's market, because of a potential bear market or simply the current level of volatility. But is now really the time to sell off your position? Or is this just a normal part of the investment cycle? Let's explore what's going on in the market and help you decide whether now is the right time to invest.
What Defines a Bear Market?
The first thing we need to do is understand what a bear market is. A bear market is when stock prices fall by 20% or more from their peak. Usually, this downtrend lasts around nine months, but this is not always the case. For example, the stock market entered bear market territory in February 2020, but it only lasted one month.
Before that, the last prolonged bear market was during the Great Recession of 2008. That downtrend lasted 17 months. The bear market in 2000 lasted 31 months. Finally, when talking about a bear market, we are speaking of the entire market in a downtrend.
What Causes Bear Markets?
There are a variety of things that can cause bear markets, but they usually happen when there's an economic recession. Other causes include rising interest rates, oil price shocks, economic shifts, and political turmoil.
In the case of the current level of market volatility, there are multiple causes. The global pandemic forced the government to spend money, which increased the inflation rate and disrupted the supply chain. Demand outpaced supply, so prices rose. The Federal Reserve was slow to react, thinking the higher inflation was temporary. Now we have a very high inflation rate and an aggressive Fed raising interest rates to get inflation under control.
High inflation and rising interest rates have forced many investors to take a defensive position, which has led to our current bear market.
Beware of a Bear Market Rally
Knowing about a bear market rally is important, as this common occurrence can harm investors. A bear market rally is when stock prices bounce off their lows for some time before returning to a downtrend.
There is no formal definition of a bear market rally. However, many experts agree it is when stock prices rise 5-10% off their lows. This rally can last a few weeks, up to a few months.
Why do these rallies happen? During a drop in prices, many investors panic and sell, sending prices lower than they should be. Long-term investors see these bargain prices and buy stocks, driving prices higher. Once this demand dries up, stock prices resume their downward trend.
Every bear market from 1901 through 2015 has had at least one 5% rally every time. Close to 66% of the time, there has been a 10% rally. Investors need to be aware of this occurrence and plan accordingly.
Inflation is High, Will it Rise More Before Going Down?
No one knows where inflation goes from here. If you talk to ten economists, you might get ten different answers. Some believe inflation has peaked and should be dropping from here. Others believe it is still rising and the last inflation report showing a cooling off is misleading. Still, others think that where inflation is today will remain for years.
As an investor, your best option is to prepare for the worst but be simultaneously flexible to take advantage of changing market and economic conditions.
This could mean taking a more defensive stand with your portfolio. Or it could mean building up a cash cushion, so you have funds to slowly invest in the market as it falls, buying stocks at a discount.
Interest Rates are Up. Will They Stay Up?
The Federal Reserve is aggressively raising interest rates, and there is no sign they will ease up until inflation returns to 2-3% annually. Because of this, investors should plan for higher interest for the foreseeable future.
While higher interest rates alone don't imply a bear market, an inverted yield curve predicts a down stock market more accurately. This is when yields on longer-term bonds are lower than those on shorter-term bonds with the same credit quality. Investors presume they will earn a higher yield on longer-term bonds since more risk is involved. When the yields flip or invert, investors are pessimistic about the economy's short-term outlook.
Seeing how the inverted yield curve has recently deepened, it is only fair to assume that an economic recession is in store for the future, if not here already.
Current Market Observations
The current market conditions point to the stock market being in a bear market with no end in sight. After dropping to the year's low in June, the market rallied over 15% by mid-August, a classic sign of a bear market rally. But then Federal Reserve Chairman Jerome Powell reiterated the Federal Reserve’s aggressive stance to keep raising interest rates. Since then, the market has been down over 5%.
There are other signs that the bear market will continue, namely higher interest rates. With higher rates, businesses will take on less debt to fund their growth. As a result, earnings estimates will decline, and investors will seek out other safer alternatives to invest in.
The one good sign is the strong U.S. Dollar. A strong dollar helps keep commodity prices, specifically oil prices, in check and tamper demand. With less demand, oil prices can begin to ease.
A Long-Term Perspective. Should I be Reallocating?
An important question investors have regarding the current state of the economy is whether they should be reallocating their portfolios. The answer to this question is complex and depends on your investment goals, time horizon, and risk tolerance.
You may not need to do anything if you have a long-term time horizon. History has shown that bear markets don't last forever, and the market always recovers. At the very least, you should put the cash you have on the sidelines to work for you by strategically investing as the market moves.
If you are closer to retirement or need to access your money in the next five years, you may want to take a more defensive stance. This could include selling some of your stocks and investing in bonds or cash. As interest rates rise, it is worth looking at certificates of deposit, as you could build a CD ladder that would provide safety from loss and offer income.
It is smart to look into Q.ai’s Investment Kits. These are pre-built investment strategies that offer a variety of themes - inflation, emerging tech, value vault, crypto, and so on - for every type of investor, whether you’re near retirement or just getting started as an investor.
It is also important to remember that no one knows when the bear market will end. By taking a more defensive stance, you are saying that you don't trust the market to rebound shortly. In doing so, you could miss out on significant gains if the recovery starts sooner than you expect. This is why you must take the time to create a detailed investment plan that assesses your risk tolerance. This will allow you to ride out any volatility in the market and ensure you are poised to take advantage when the market eventually does rebound.
Is This a Buying Opportunity For Stocks?
Any time the stock market drops by a significant amount, say 20% or more, it usually signals a buying opportunity. The issue is that no one knows where or when the bottom will occur. In other words, just because the market is down 20% doesn't mean it will rally from here. It could trade sideways for a bit or trend even lower.
Because no one knows, a smart approach is to dollar cost average your investments. This allows you to invest a small portion of your investable cash every few months. For example, if you have $10,000, you could invest $2,000 every month for five months. Doing this increases your chances of buying at the lows, so you can earn a more significant return as the market moves higher.
Bottom Line
The stock market is in a bear market, and all economic signs indicate an extended stay here. As an investor, the last thing you want to do is make an emotional decision with your money. Instead, take the time to understand what a bear market looks like and how it typically acts. From there, you can build your portfolio or reallocate it to allow you to stay invested without losing sleep at night.
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