What is a bear market and what does it mean for investors?

A late rally on Friday put the S&P 500 in the green, but with the prevailing sentiment remaining negative, the relief may be temporary

High inflation has been a factor forcing investors to reconsider the prices they are willing to pay for a range of stocks. AFP

The bear came close to Wall Street but then backed off.

The stock market’s slump this year briefly pulled the S&P 500 into what is known as a bear market on Friday, before a late rally put the index in the green. The prevailing sentiment among investors remains negative, however, so the relief may be temporary.

Rising interest rates, high inflation, the war in Ukraine and a slowdown in China's economy have caused investors to reconsider the prices they are willing to pay for a wide range of stocks, from high-flying tech companies to traditional carmakers. Big swings such as the one seen Friday have been common.

The last bear market happened two years ago, but this would still be a first for those investors that got their start trading on their phones during the pandemic. For years, thanks in large part to extraordinary actions by the Federal Reserve, stocks often seemed to go in only one direction: up.

Now, the familiar rallying cry to “buy the dip” after every market wobble is giving way to fear that the dip is turning into a crater.

Here are some common questions asked about bear markets.

Why is it called a bear market?

A bear market is a term used by Wall Street when an index like the S&P 500, the Dow Jones Industrial Average, or even an individual stock, has fallen 20 per cent or more from a recent high for a sustained period of time.

Why use a bear to represent a market slump? Bears hibernate, so bears represent a market that's retreating, said Sam Stovall, chief investment strategist at CFRA. In contrast, Wall Street's nickname for a surging stock market is a bull market, because bulls charge, Mr Stovall said.

The S&P 500 index, Wall Street’s main barometer of health, rose less than 1 point on Friday, leaving it 18.7 per cent below its high set on January 3. The Nasdaq is already in a bear market, down 29.3 per cent from its peak of 16,057.44 on November 19. The Dow Jones Industrial Average is about 15 per cent below its most recent peak.

The most recent bear market for the S&P 500 ran from February 19, 2020 through March 23, 2020. The index fell 34 per cent in that one-month period. It is the shortest bear market yet.

What's bothering investors?

Market enemy No 1 is interest rates, which are rising quickly as a result of the high inflation battering the economy. Low rates act like steroids for stocks and other investments, and Wall Street is now going through withdrawal.

The Federal Reserve has made an aggressive move away from propping up financial markets and the economy with record-low rates and is focused on fighting inflation. The central bank has already raised its key short-term interest rate from its record low near zero, which had encouraged investors to move their money into riskier assets such as stocks or cryptocurrencies to get better returns.

This month, the Fed signalled additional rate increases of double the usual amount are likely in coming months. Consumer prices are at the highest level in four decades, and rose 8.3 per cent in April compared with a year ago.

The moves by design will slow the economy by making it more expensive to borrow. The risk is the Fed could cause a recession if it raises rates too high or too quickly.

Russia’s war in Ukraine has also put upwards pressure on inflation by pushing up commodities prices. And worries about China’s economy, the world’s second largest, have added to the gloom.

Do we just need to avoid a recession?

Even if the Fed can pull off the delicate task of tamping down inflation without triggering a downturn, higher interest rates still put downwards pressure on stocks.

If customers are paying more to borrow money, they can’t buy as much stuff, so less revenue flows to a company’s bottom line. Stocks tend to track profits over time. Higher rates also make investors less willing to pay elevated prices for stocks, which are riskier than bonds, when bonds are suddenly paying more in interest thanks to the Fed.

Visitors wearing Lady Liberty souvenir headwear outside the New York Stock Exchange. The S&P 500 index, Wall Street’s main barometer of health, rose less than 1 point on Friday, leaving it 18.7 per cent below its high set on January 3. AP

Critics said the overall stock market came into the year looking pricey versus history. Big technology stocks and other winners of the pandemic were seen as the most expensive, and those stocks have been the most punished as rates have risen. But the pain is spreading widely, with shares of Target and other retailers slumping hard this week after reporting weaker-than-expected profits.

Stocks have declined almost 35 per cent on average when a bear market coincides with a recession, compared with a nearly 24 per cent drop when the economy avoids a recession, according to Ryan Detrick, chief market strategist at LPL Financial.

Should investors sell everything now?

If you need the money now or want to lock in the losses, yes. Otherwise, many advisers suggest riding through the ups and downs while remembering the swings are the price of admission for the stronger returns that stocks have provided over the long term.

While dumping stocks would stop the bleeding, it would also prevent any potential gains. Many of the best days for Wall Street have occurred either during a bear market or just after the end of one. That includes two separate days in the middle of the 2007-2009 bear market where the S&P 500 surged roughly 11 per cent, as well as leaps of better than 9 per cent during and shortly after the roughly month-long 2020 bear market.

Advisers suggest putting money into stocks only if it will not be needed for several years. The S&P 500 has come back from every one of its prior bear markets to eventually rise to another all-time high.

The down decade for the stock market following the 2000 bursting of the dot-com bubble was a brutal stretch, but stocks have often been able to regain their highs within a few years.

How long do bear markets last and how deep do they go?

On average, bear markets have taken 13 months to go from peak to trough and 27 months to get back to break even since the Second World War.

The S&P 500 index has fallen an average of 33 per cent during bear markets in that time. The biggest decline since 1945 occurred in the 2007-2009 bear market when the S&P 500 fell 57 per cent.

History shows that the faster an index enters into a bear market, the shallower they tend to be. Historically, stocks have taken 251 days (8.3 months) to fall into a bear market. When the S&P 500 has fallen 20 per cent at a faster clip, the index has averaged a loss of 28 per cent.

The longest bear market lasted 61 months and ended in March 1942 and cut the index by 60 per cent.

How do we know when a bear market has ended?

Generally, investors look for a 20 per cent gain from a low point as well as sustained gains over at least a six-month period. It took less than three weeks for stocks to rise 20 per cent from their low in March 2020.