Bear Market - Explained
What is a Bear Market?
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Table of ContentsWhat is a Bear Market?How Does a Bear Market Work?Academic Research on Bear Market
What is a Bear Market?
A bear market refers to a market situation wherein there is a steep fall in the prices of securities, resulting in an overall sentiment of negativity in the stock market. Such an internally-motivated decline of the market instigates a sense of apprehensiveness in investors, leading them to panic sell their holdings. Although the technical definition of a bear market is far from unambiguous, a market can safely be assumed to have entered a bearish phase when it exhibits a decline of at least 20 percent from its peak in several market indices over a span of two months.
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How Does a Bear Market Work?
In sharp contrast to a bear market is a bull market, which represents a market condition wherein there is a sharp rise (or an anticipation thereof) in prices of securities. While the term bull market analogizes such a condition with the upward thrusts of a bulls horns during an attack, the term bear market is analogous to the downward wallop of a bears paws during an ambush. Technical definitions of a bear market are rather ambiguous; however, any drop of at least 20 percent over a span of two months can be termed a bear market. Several factors contribute to a bear market; the most obvious being an overall stagnant economy that brings with it repercussions such as widespread unemployment, and a reduction in income and profits. Another significant factor is government interference in the economy by way of changes in tax rates. Also, investors play a crucial role in determining a bear market. Often, investors will anticipate a downtrend in the market and will, consequently, indulge in mass selling of shares in order to avoid future losses. Typically, a bear market exhibits four distinct phases:
- A phase of surging share prices. Although this heightens investor sentiment, they typically begin to indulge in profit-booking, thus liquidating their holdings.
- The second phase witnesses a sharp fall in share prices, thus significantly affecting profits and investor sentiment and possibly causing apprehension among investors.
- The third phase of the bear market marks the entry of speculators into the market. This may result in a partial increase in prices as well as volume of trade.
- The fourth phase witnesses a much slower drop in share prices, ultimately leading to a situation where the low share prices seem lucrative to new investors. This newfound interest heralds the transition into a bull market.
However, as similar as they may seem, bear markets are not the same as market corrections, the two principal differences being;
- Unlike bear markets, a market correction is a much shorter-term price movement, typically lasting less than two months.
- Unlike bear markets that do not offer scope for a bottom indicator, market corrections do provide traders with an discernible entry point.
Short selling is an important feature of bear markets that allows investors to make profits by liquidating borrowed security that is anticipated to fall in value and subsequently purchasing them when prices actually fall. Such a procedure mandates the borrowing of shares by the short seller from a broker before a short sell is initiated. The short sellers earnings can be measured as;
Total earnings = (Selling price of securities) - (Buy-back price of securities)
In case the short seller is forced to buy back securities at a price higher than his selling price, his total earnings will be negative, i.e. a loss will be incurred. A put option is a stock market instrument that allows the buyer of the option to voluntarily sell his stocks at a price he favors on a predetermined date. Utilized mostly as speculative tools, put options allow traders to purchase stock with falling prices and long-term investors to hedge their investments.