Last Updated on September 19, 2022 by Quantified Trading
The financial markets always cycle between bull and bear markets. If you want to trade the stock market, you should know how to play both market conditions. So, what is a bear market trading strategy?
Bear market strategy refers to the techniques traders and investors use to trade the market during a bear run. They include entry, exit, trade management, and risk management strategies investors use to protect their assets and even make some profits during a bear market. At the end of the article we provide you with a bear market strategy.
Let’s take a look at some bear markets in history.
What is a bear market?
A bear market, also known as a bear run, refers to a market condition where the prices of assets are on a steady decline. But since the prices of financial assets are always fluctuating, the term “bear market” typically describes a prolonged period (more than one month) of a downtrend in asset prices. The term is more commonly used to describe the stock market, but it can also be used for other asset markets, such as the commodity, bond, foreign exchange, and real estate markets.
As regards the level of a price decline that qualifies for a bear market, the commonly accepted definition is a decline of 20% or more from the most recent high in any of the broad market indexes, such as the S&P 500 Index or the Dow Jones Industrial Average (DJIA), over a period of at least one month. However, many retail and institutional traders have a simple way of using the 200-day moving average of the S&P 500 Index to identify a bear market — when the 200-day moving average of the S&P 500 is sloping downward and the index is trading below it, the market is considered to be in a bear run.
A bear market is characterized by high levels of pessimism and a lack of interest in the stock market, with many eager to pull out of the market at any cost — what traders and investors call bearish sentiment. A bear market follows a bull market, possibly after a period of distribution, and it is in turn followed by another bull market after accumulation, completing the Wyckoff trading strategy (market cycle) — a bear market, an accumulation period, a bull market, and a distribution period.
There are no specific rules of a bear market, of course. However, you should define a bear market by quantified rules.
What causes a bear market?
Many factors can be responsible for bringing in a bear market. The prominent ones include the following:
- Overvaluation of stocks: When stocks get extremely overvalued, far more than their fundamentals suggest (with outrageous P/E ratios), the bubble would eventually burst, and prices decline to their true values. While this often comes in the form of market corrections, a correction may be severe enough to trigger a bear market.
- Negative investors’ sentiment: Stocks are traded by human beings, so stock price movement often reflects human emotions — fear and greed. When investors lack interest in the market, the demand for stocks declines, which can lead to a bear market.
- Economic decline: The stock market and the state of the economy are intrinsically related, and here’s why — the stocks that trade on the market belong to the businesses which make up the major part of the economy. When there is a recession in the economy, businesses don’t make enough profits, and some may even be in losses since consumers don’t spend as much as they used to. This affects stock valuations, leading to a decline in stock prices.
- Escalating inflation: A sudden rise in the price of commodities, such as crude oil, gasoline, diesel, wheat, and so on, can affect the prices of other goods and services in a significant way, leading to high inflation. This forces the government to act to bring down inflation, which ends up causing a market decline.
- Hawkish government policies: The government controls the economy through fiscal and monetary policies. For example, the Federal Reserve can raise interest rates. A high interest rate would make the cost of borrowing too high for businesses, leading to less productivity and a decline in the economy, which, in turn, causes a decline in the stock market.
What does a bear run mean?
A bear run is another name for a bear market. It implies that bears (sellers) are dominating the market for an extended period, with overall stock prices on the decline. Generally, it describes a period of more than one month when a broad market index has declined by 20% or more from the most recent high.
During a bear run, the market stock prices are in an aggressive decline, as investors trip over themselves to get out of the market they perceive to be extremely risky. The market is engulfed by pessimism and fear, dragging prices down. The extreme sell pressure can lead to capitulation, a situation where investors accept any price just to get out of the market. This leaves stock at extremely low prices — undervalued, which may prompt value investors to come and mop up stocks at discounts.
What are some bear market examples?
There are many bear markets in the history of the U.S. stock market, but we will focus on the ones that happened after the turn of the millennium.
The Dot-Com Burst (2000-2002)
After the ridiculous bull run at the end of the 1990s, especially in tech and internet stocks, which Alan Greenspan, the then Fed chairman, described as irrational exuberance, the market came crashing in the early 2000s. Obviously, the cause of the bear market was the extreme overvaluation of internet stocks.
The Nasdaq composite, which consists mainly of tech stocks, lost about 78% of its value until it bottomed in 2003, while the S&P 500 index lost about 49% in that dot-com burst as it is now known.
We have written an article about the anatomy of a bear market and specifically covered the dot com bust:
The Great Financial Crisis (2008/2009)
The bear market was caused by a bubble in the US housing market brought about by banks’ loose lending practices for mortgages (particularly subprime mortgages). It is the worst bear market since the Great Depression. Some banks declared bankruptcy, which affected the global financial markets, causing economic recession around the world.
The bear run lasted for about a year and five months, between 2008 and 2009, with the S&P 500 declining nearly 57% from its peak and many losing their retirement investments.
The Covid-19 Pandemic Market Crash (2020)
This bear market, which was caused by the Covid-19 pandemic and the economic lockdown policy initiated by the governments, lasted only 33 days between February and March 2020. Within that period, the S&P 500 index lost about 34% from its pre-pandemic high. The market recovered very fast because the U.S. government injected trillions of dollars into the economy in the form of stimulus and direct relief payments.
The 2022 Bear Market
The market has been on the decline since January 2022, but the S&P 500 officially entered the bear market territory in mid-June when the index had declined by over 21% from its all-time high on January 3.
The cause of the bear market is related to extreme inflation, following the unprecedented injection of trillions of dollars into the economy in the form of Covid-19 relief packages. It was only worsened by geopolitical crises in Eastern Europe (Russia/Ukraine crisis).
How long does a bear market last?
A bear market can last as long as possible, but it usually ranges from two months to five years or more. The average duration of a bear market is generally much shorter than that of the bull market, but bear markets tend to be more aggressive than bull markets.
Studies have shown that the average duration of a bear market is about a year and nine months. This is even because the data was skewed by the 1929 great depression. In recent times, the duration of bear markets is considerably shorter than the bear markets of the 1930s and 1940s. There are many reasons for this, but the common ones include the introduction of circuit breakers, easy access to information, fast government interventions to economic declines, and the general belief that the market would eventually recover.
Bear market trading strategy no 1 (backtest and example)
Let’s go from theory to practice: We backtest a bear market strategy in the stock market. The backtests below are done on S&P 500/SPY from its inception in 1993 until today. SPY is the oldest ETF still around and thus has a long time series to backtest on.
The beauty of a bear market is threefold:
- Volatility picks up. A bear market typically has twice the volatility as a bull market. And as a trader you would want high volatility to prey on.
- The second advantage of a bear market is that short strategies tend to work very well. Short strategies don’t work in calm, bull, and rising markets.
- The last advantage is for long-term investors: you get to load up at much lower prices.
Short trading strategies are very hard to come by – no matter the market. The stock market is particularly difficult to short because it has an in-built bias from the overnight edge. When you are fighting such a headwind, it’s wiser to focus the energy elsewhere and rather wait for the right moment to strike (like a barracuda).
Such a right moment (to strike like a barracuda) for shorting the stock market is when we have a bear market. However, you need to set precise trading rules and settings to define a bear market.
We have built a long AND short bear strategy that only trades when volatility picks up during a bear market. Both long and short have three parameters to enter a trade and just one parameter to define when to exit the trade. Long and short trades are the same for both market directions, but opposite values (of course).
The equity curve of the long and short strategy looks like this (read our take on what is a good equity curve?):
In our opinion, the results are very good (we partially trade it ourselves). This is the strategy performance metrics:
The bear market trading strategy has a Compound Annual Growth Rate (CAGR) of 6.33% while only being invested 6.7% of the time (look at the row called “exposure”). The number of short trades is 43% of total trades and short trades contribute significantly to the overall result.
If we look at the respective annual gains the table looks like this:
Take notice of the huge returns when the stock market is weak: 2002, 2008, 2020, and 2022. This strategy is huge contribution a portfolio of trading strategies. In trading, you want complementary trading strategies, not necessarily the “best” strategies. The best strategy might not have the best trading metrics but the lowest correlation to the existing strategies!
We don’t want to reveal the trading rules of our bear trading strategy because we reserve it for our paying monthly trading edge subscribers.
Bear market trading strategy no 2 (backtest and example)
During the bear market of 2022 we published a new strategy bundle:
The combined equity of all the strategies traded as one portfolio is displayed here:
Bear market trading strategy no 3: the barbell strategy
If you are more of a long term investor (buy and hold) and not a short-term trader, you might not be interested in shorting and trading at all. If so, is there any way you can hedge your positions if there is a brutal bear market?
Yes, there is. Nassim Nicholas Taleb has been an advocate of tail risk hedging strategies through his barbell Strategy.
The main purpose of the barbell strategy is to have assets that are binary to each other. One side of the barbell has low-risk assets, and the other side of the barbell has high-risk assets. These are assets that are totally uncorrelated to each other and that mitigate risk (please read about Mark Spitznagel on how to mitigate risk).
Also, below are a few older articles on correlation in trading that is very worthy of reading if you are serious about trading and investing:
- What does correlation mean in trading? (Trading strategies and correlations)
- Uncorrelated assets and strategies – benefits and advantages (examples and backtests)
- Does your trading strategy complement your portfolio of strategies?
- Why build a portfolio of quantified strategies (including two strategies)
Bear market trading strategy no 4: tail risk hedging strategies
Is there an easier way to protect against black swans and unpredictable events (that leads to bear markets)?
The simplest way is to purchase put options on a broad market index, for example the S&P 500. A put option is like insurance. This costs money, however, and you “bleed” along the way. But that’s the price you pay for paying for insurance!
You can also invest in a tail risk ETF, for example one by Cambria’s tail risk ETF. We have covered this option (and more) in our article about tail risk hedging strategies.
Bear market trading strategy no 5: the All Weather Portolio
The All Weather Portfolio is a very famous portfolio developed by Ray Dalio. The portfolio was made by him and his employees at his Bridgewater Assosiates hedge fund and the portfolio is made to withstand any investing climate: inflation, stagflation, deflation, etc. The main idea behind the portfolio is asset diversification.
We both explained and made a backtest of the All Weather Portfolio in a previous article.
Bear market trading strategy no 6: trend following strategies
If you have read so far, you might already understand that correlation (or better lack of it) is key in portfolio management. One type of strategy stands out: trend following. Trend following tends to gain in difficult times. The few random outliers are to you advantage!
For long periods of time you might have to hold tight into your boat as you get whipsawed back and forth (and slowly leaking), until you hit the perfect wave or breeze and you get carried away a long distance. The few big winners often recoup the small losses along the way.
We can give you a perfect example of that in this table:
|Year||Paul Mulvaney Trend
||Eurekahedge||Barclay CTA Index||Lynx||S&P 500|
The four first columns are either trend following funds or trend following indices. Please pay attention to the years when the S&P 500 is negative. Normally, the good trend following funds perform well in bad years for the S&P 500. That means trend following is a very good hedge and work as a bear market strategy!
Bear market trading strategy – ending remarks
Both long-term investors and short-term traders should love a bear market. Long-term investors should love it because they can buy cheaper (and not sell!), while short-term traders can profit from increased volatility and gains from short trades. A bear market trading strategy is significantly different from a bull market trading strategy, both in terms of volatility and length. Thus, a good bear market trading strategy is to be active and seize the opportunity!