What is a Bear Market?

Definition & explanation:

The term bear market or bear market denotes a period in which there is a sharp fall in the price of an asset class or financial instrument. There is no generally accepted definition of when a market is in a bear market – typically, a decline of at least 20% from its peak has become the rule of thumb.

A bear market is usually referred to in connection with stock indices, but price losses in commodities, individual stocks and other financial instruments are also sometimes referred to as a bear market.

If a bear market occurs on the stock markets, it is often accompanied by general pessimism and/or recession.

In this article we will limit ourselves to the term bear market, in connection with stock markets or stock indices.

Key takeaways:

  • The terms bear market and bear market refer to a phase in which stock markets experience strong price losses.
  • As a rule of thumb, if prices fall by 20% or more, a market is in a bear or bear market.
  • Before the beginning of a bear market, there is a distribution phase in which a top formation is formed in terms of the chart and then a new primary downward trend develops.
  • A bear market signals an economic slowdown or a recession.

How do you recognize a bear market?

There are clear signs of bear markets:

Bear markets have some typical characteristics. If you know these characteristics and you know what to look for, you can recognize a bear market relatively well. Besides the question how many percentage points a market has fallen, there are other things you should focus on and include in your trading decisions.

To get a better understanding of the different market phases, we will discuss the 20% rule, other methods for determining the market phase, and typical characteristics of bear markets.

The 20% Rule

The rule of thumb mentioned above – I call it here the “20% rule” – is widely used and especially media often refer to the 20% rule. If a market falls by 20% or more from a local high point, it is commonly believed to be in the “bear retorium”.

As a rough guide, the 20% rule is quite useful. However, one should not focus solely on this when asking whether we are in a bear market. In particular, one should not make trading decisions solely based on whether a market has fallen 19% or 21%.

Criticism of the 20% rule

If you restrict yourself to the 20% rule, some problems will arise:

  • Which stock index is used
  • If only one or more indices are observed
  • Indices have varying volatility
  • temporal extension also plays a role
  • Index is not always ideally suited to reflect the broad market
  • Trend/market technique should be considered

When it comes to the question which index should be monitored, the following usually prevails Match. For example, the S&P 500 is the benchmark for the American stock market; in Germany, this is the DAX.

However, the first problem already arises here. The DAX is a so-called performance index – i.e. the price includes dividend payments – while the S&P 500 is a price index (dividends not included). To examine the actual performance of the S&P 500, some analysts therefore use the S&P 500 Total Return Index, others the S&P 500 Index.

Nevertheless, leading indices of different countries often have fundamentally different volatility. This means that the index of one country may have a higher fluctuation margin than the index of another country. So why should 20% be used as the “bear market limit” in both cases?

If there are very fast and strong price rises, a larger correction is also not unusual and sometimes happens very quickly. However, a “real” bear market is usually preceded by a distribution phase (redistribution phase), in which the market forms a top and then a clearly recognizable technical downward trend. This usually takes several months. The mere limitation to the 20% rule also fails to take account of this fact.

Correction or bear market?

When prices fall, the question arises: Are we in a correction or already in a bear market? Another rule of thumb says: price declines of 10% – 20% are called a correction.

The term “correction” is used here in a different context than followers of the Dow theory or market technique do. The latter focus on the trend rather than the percentage points.

However, the “10% rule” is also roughly simplified, which is why we will delve a little deeper into the subject below:

Features of bear markets

  • Stock indices have recorded strong price losses (large caps, mid caps, small caps).
  • The entire market (the broad market) is affected – not just some indices or sectors.
  • Before a bear market begins, there is a distribution phase. Here, sales take place under high volume.
  • In terms of charts, the distribution phase can be recognized by a top formation.
  • A bear market shows a clear chart technical primary downward trend (see Dow theory).
  • Falling below the 200 moving averages on a daily and weekly basis are often (early) warning signals.
  • During the distribution phase, defensive market sectors show relative strength, while offensive market sectors show relative weakness.
  • The beginning of a bear market is a good early indicator of a recession.
  • During a recession, stock markets already start to rise again.
  • Bear markets are accompanied by “media doomsday mood”.
  • High-risk asset classes are generally avoided, “safe havens” will benefit.

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