The anatomy of a bear market
Many traders believe, as a rule of thumb, that a bear market is a market that goes down 20% or more. But there is, of course, no official rule, but a bear market is regarded as both longer and steeper than a correction. However, as a trader, the most important thing is that volatility picks up. Perhaps ironically, long strategies tend to perform better in a falling than a rising market. Even better, short strategies suddenly start working when volatility picks up.
In this article, we look at some statistics of the bear market of 2000 to 2003 – the aftermath of the dot-com excesses. Bull and bear markets are a natural part of the stock market lifecycle and every trader should have a bear market trading strategy. By continuing reading, you will learn why you should welcome a bear market, whether you are an investor or a trader.
What are the characteristics of a bear market?
Bear markets are known for their high volatility and sharp rallies. Volatility picks up:
The chart above shows the 15-day ATR (average true range) which cools off dramatically after March 2003 when the market bottomed. Markets sell off “spectacularly” but rise slowly.
How long does a bear market last?
A bear market lasts much shorter than a bull market. This is important because bad times get discounted quickly and lead to high volatility and thus more prey for traders.
Depending on the criteria and definitions, the stock market tends to spend about 80% in a bull market and only 20% in bear markets (according to many websites – we have never looked at any numbers ourselves).
Many use the 200-day moving average as an indicator of a bear and bull market. When the price is above the 200-day moving average, we have a bull market and vice versa. How much of the time has the S&P 500 spent above and below this long-term moving average?
The S&P 500 has spent 70% of the time above the 200-day moving average since 1960 and 85% of the time since 2010.
Bear markets tend to take far longer to fully recover
Bear markets normally lead to sudden drops in equity values, but they require far more time to recover. For example, the market set a new all-time high in late 2006 – 6.5 years after the top in 2000.
Bear markets are inevitable and frequent
The current bull market from 2010, only interrupted by very brief and powerful “corrections” in 2011, 2018, and 2020 (a short recession?), has made many investors and traders complacent.
Central banks and “stimuli” come to the rescue, which has changed the game considerably. However, it’s unlikely that the stimulus will avoid future recessions and subsequent drops in asset prices. Perhaps the contrary, fiscal stimulus, and money printing just lead to bigger future financial disasters.
Bear markets are good
There are many reasons to appreciate a bear market, both if you’re an investor or a trader.
Moreover, there are strong reasons to believe bear markets and recessions have a purpose in “cleaning out excesses” in the economy. Humans are, in general, extremely adaptable and many good innovations see the day of light during necessity.
Why an investor should love a bear market
A long-term investor should love a bear market as it allows you to buy at “cheaper” prices. If you’re a future net buyer of stocks you want to pay as little as possible for earnings, thus you should welcome a bear market.
Unfortunately, the mindset of most people is different: they are happy when the stock prices rise, despite having to pay more for the same earnings.
Moreover, many stocks buy back shares on a regular basis, even though the earnings multiple might be over 40. You get more bang for the buck the lower the prices.
Why a trader should love a bear market
Likewise, a short-term trader should love falling prices. First, volatility normally picks up, which is mostly positive. In a previous article, we wrote about volatility trading in the S&P 500 and showed how both long and short work very well when volatility picks up and prices fall.
Second, even trading from the long side gets better when volatility picks up.
Third, volatility increases the opportunity to make money on the short side. Volatility is what makes the prey for the short-term trader (if you know what you’re doing).
As an example, let’s use the very simple strategy combining RSI and a second indicator on QQQ (Nasdaq) which goes long on weakness (mean-reversion):
- RSI(2) On QQQ (Nasdaq)
The results during the dot-com recession from March 2000 until October 2002 produced 38 trades with an average gain of 2.07% and a win ratio of 68%.
During the GFC, from October 2007 until April 2009, the strategy made 19 trades with an average gain of 2.14% and a win-ratio of 73%.
What about Covid-19? The same strategy made two trades between February and mid-April 2020: two winners of 0.5% and 5.45%.
How to prosper during a bear market
If you’re an automated trader there is most likely no reason to change anything.
If you’re a long-term investor, just keep on adding to your positions. When the risk premium increases you can expect higher returns in the future.
The only time to worry about a bear market is if you’re about to retire or withdraw funds.
What happened in the S&P 500 during the bear market of 2000 – 2003?
The below chart shows the “double top” on the first of September 2000 and the “triple bottom” on the 12th of March 2003, which (in hindsight) marks the bottom of the bear market:
The S&P 500, dividend-adjusted, fell 45% during this timeframe. Here are some interesting statistics (measured from the close of today until tomorrow’s close):
- The number of up days: 304
- The number of down days: 326
- The average up day: 1.13%
- The average down day: -1.21%
- The median up day: 0.74%
- The median down day: -0.89%
The distribution of all days looks like this (both for positive and negative days):
What happened in the Nasdaq 100 during the bear market of 2000 – 2003?
Nasdaq topped out earlier, in March 2000, but bottomed out earlier than the S&P 500 in October 2002 after dropping more than 80%:
The chart above is not adjusted for dividends, and it shows it took 15 years for the tech stocks to fully recover from the exuberance of the dot-com bubble!
It was 295 up days and 333 down days. The distribution looks like this:
The distribution of all days (both for positive and negative days) in QQQ:
The anatomy of a bear market – conclusion
The anatomy of a bear market is mainly about volatility. A trader should love increased volatility!
– How long does a typical bear market last?
Bear markets are relatively short-lived compared to bull markets, as bad times get discounted quickly. Their duration can vary, but they tend to be shorter than bull markets.
– What role does volatility play in a bear market?
Volatility significantly increases during bear markets, creating opportunities for traders. Both long and short strategies tend to perform well in a falling market with heightened volatility.
– Why are bear markets considered inevitable and frequent?
Bear markets are a natural part of the stock market lifecycle, occurring approximately 20% of the time. They are essential for “cleaning out excesses” in the economy and fostering innovation.