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What is a 'Bear Market'

A bear market is a condition in which securities prices fall and widespread pessimism causes the stock market's downward spiral to be self-sustaining. Investors anticipate losses as pessimism and selling increases. Although figures vary, a downturn of 20 percent or more from a peak in multiple broad market indexes, such as the Dow Jones Industrial Average (DJIA) or Standard & Poor's 500 Index (S&P 500), over a two-month period is considered an entry into a bear market.

BREAKING DOWN 'Bear Market'

The term “bear market” is the opposite of a “bull market,” or a market in which prices for securities are rising or will expect to rise. It is named for the way in which a bear attacks its prey — swiping its paws downward. This is why markets with falling stock prices are called bear markets. Just like the bear market, the bull market is named after the way in which the bull attacks by thrusting its horns up into the air. 

While there is no agreed upon definition of what makes a bear market, it's generally accepted that a bear market is characterized by a drop of 20 percent or more over a two-month period. 

What Causes a Bear Market?

The causes of a bear market often vary, but in general, a weak or slowing or sluggish economy will bring with it a bear market. The signs of a weak or slowing economy are typically low employment, low disposable income and a drop in business profits. In addition, any intervention by the government in the economy can also trigger a bear market. For example, changes in the tax rate or in the federal funds rate can lead to a bear market. Similarly, a drop in investor confidence may also signal the onset of a bear market. When investors believe something is about to happen, they will take action — in this case, selling off shares to avoid losses. 

Phases of a Bear Market

Bear markets usually have four different phases. The first shows high prices and high investor sentiment. But in this phase, investors are beginning to drop out of the markets and take in profits. In the second phase, stock prices begin to fall sharply, trading activity and corporate profits begin to drop, and economic indicators that may have once been positive start to become below average. Some investors begin to panic as sentiment starts to fall. The third phase shows speculators start to enter the market, therefore raising some prices and trading volume. In the fourth and last phase, stock prices continue to drop, but slowly. As low prices and good news starts to attract investors again, bear markets start to lead to bull markets.

Bear Market vs. Correction

A bear market should not be confused with a correction, which is a short-term trend that has a duration of fewer than two months. While corrections offer a good time for value investors to find an entry point into stock markets, bear markets rarely provide suitable points of entry. This is because it is almost impossible to determine a bear market's bottom. Trying to recoup losses can be an uphill battle, unless investors are short sellers or use other strategies to make gains in falling markets. Between 1900 and 2015, there were 32 bear markets, averaging one every 3.5 years. The last bear market coincided with the global financial crisis occurring between October 2007 and March 2009, during which time the DJIA declined 54 percent during the period.

Short Selling in Bear Markets

Investors can make gains in a bear market by short selling. This technique involves selling borrowed shares and buying them back at lower prices. A short seller must borrow the shares from a broker before a short sell order is placed. The short seller’s profit and loss amount is the difference between the price at which the shares were sold and the price at which they were bought back, referred to as "covered." For example, an investor shorts 100 shares of a stock at $94.00. The price falls and the shares are covered at $84.00. The investor pockets a profit of $10 x 100 = $1,000.

Put Options and Inverse ETFs in Bear Markets

A put option gives the owner the right, but not the obligation, to sell a stock at a specific price on, or before, a certain date. Put options can be used to speculate on falling stock prices, and to hedge against falling prices to protect long-only portfolios. Investors must have options privileges in their accounts to make such trades. Inverse ETFs are designed to change values in the opposite direction of the index they are tracking. For example, the inverse ETF for the S&P 500 would increase by 1% if the S&P 500 index decreased by 1%. There are many leveraged inverse ETFs that magnify the returns of the index they track by two and three times. Like options, inverse ETFs can be used to speculate or protect portfolios.

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