You can buy a hundred books on how to pick good stocks, but hardly any on how to avoid falling ones. You might come across the occasional gloomy article in the financial press, but for the most part editors like to accentuate the positive.Here, is an effort to educate the blog readers about this inevitable evil and possible ways to wriggle out of a bear attack. This is the first part of the bear market posts.
You can buy a hundred books on how to pick good stocks, but hardly any on how to avoid falling ones. You might come across the occasional gloomy article in the financial press, but for the most part editors like to accentuate the positive.
The bear hardly gets the focus and understandably so.
Success is more appealing than failure – to all of us.
Most investors are naturally optimistic – they’d rather read about prices going up than down.
In growth economies like India, bulls have done so well for so long that we’ve all rather forgotten what bears are like.
Bears, in short, are the party-poopers of the investment world. They spoil the fun.
The trouble is that they are also an indigenous feature of the investing landscape. On average you’ll bump into one every 4-6 years. And the chances are you won’t be prepared for it. You’ll panic and run, or try to fight, or be paralysed with indecision. None of these is likely to safeguard your vital assets.
Here is a bit on bear market and the ways to wriggle out of it, may not be uninjured but surely alive.
Bear Market definition:
A bear market is another name for a lengthy downturn in share prices. Bears are investors who expect prices to fall. Bulls expect them to rise. When the pessimists have the upper hand, there are more sellers of shares than buyers, prices fall, and, if the fall is steep and long enough, you have a bear market.
But how steep does the decline have to be to qualify as a bear market? The usual answer is that there has to be a sustained fall in stock market indices of more than 20% from the recent high. Note the three parts of that definition:
‘Sustained’: which means that a general fall in prices that lasts for a few weeks doesn’t count.
‘Stock market indices’: which means that sharp falls in individual stocks, or in particular sectors, doesn’t constitute a bear market if other stocks/sectors are doing fine.
‘20%’: which means that smaller percentage falls don’t officially count as bear markets.
To be pedantic, a 10% fall in two trading days may feel like a bear market to you, but technically, it isn’t one. It’s a correction. And if it takes the edge off a rampant bull market, then arguably it’s a healthy development.
There is nothing healthy about a real bear market. They happen rarely. But when they do the sharpness of the decline, and its intractability, will come as a shock to investors hurting them and robbing them off their capitals.
Why do bear markets happen?
Simply, when sellers outnumber buyers.. Equity bear markets are unplanned, disorderly, infused with anxiety, and not controllable by any one person or group of people.
Why do they happen? There can be lots of reasons:
1. Realisation that the fundamentals are unrealistic
This is a version of The Emperor’s Clothes. When companies are trading on P/E ratios of 30+, investors are being asked to pay an amount which will take thirty years to recover. In a bull market, they go along with the joke because everyone else is. At some point the consensus changes.
2. Economic fundamentals
Real bear markets, the ones that lasts longer, tend to be caused by, and in turn cause economic downturn. There’s a logical reason for this:
It’s a circular process which works both ways.
Working forwards: If people feel confident about the economy, they tend to spend more and save less, which means companies make higher profits, which means share prices go up, which means people feel more confident about the economy, which means . . .
Working backwards: if people don’t feel confident about the economy, they tend to save more and spend less, which means companies make lower profits, which means share prices go down, which means people feel less confident about the economy, which means . . .
Money in the economy
Through monetary and fiscal measures, governments can either encourage or tighten consumer spending.
The more people save, the less they spend, and vice versa. So savings behaviour has a big effect on economies. When people feel confident about their jobs, and well-off because of rising share prices, and the cost of borrowing is cheap, their spending tends to be high relative to savings. When confidence is low, and share prices dip, and inflation starts to climb, the reverse is true. Savings habits can provide foresight of corporate profits.
It has been a general trend for companies, particularly in India, to increase their borrowings. This is partly because it was cheaper to raise money this way than by issuing shares. In an economic downturn, companies find it more difficult to take on debt or refinance existing borrowings. This can lead to crises of confidence and an adverse impact on share prices.
Often major political events cause bear markets. In 1973-1974 the Middle Eastern oil embargo, together with Watergate and the Yom Kippur War shattered Western confidence. In 1990, Sadam’s invasion of Kuwait did the same. The Vietnam War and the Falklands War took their toll.
Wars in general have not been good for stock markets, contradicting the Rothschild maxim ‘Buy to the sound of cannons. Sell to the sound of trumpets.’
The depth of an event-inspired bear market seems to depend on how the event pans out. The quadrupling of oil prices caused a severe bear market because it had real economic impact. Sadam’s invasion of Kuwait did not, because militarily he was quickly ejected.
How to spot a bear market is coming!
No bell rings to announce the start of a bear market and bull markets often begin in similar muted fashion.
But the final phase of a bull market, which precedes the start of a bear market, is usually accompanied by a number of signals:
An indiscriminate and exponential rise in prices
The widespread belief that ‘it’s different this time’
Widespread fear of ‘missing out’ on the next hot stock
The abandonment of traditional methods of valuing shares
High levels of trading volume and increased involvement of retail investors
Major phases of a bear market
Historically, major bear markets have also followed distinct patterns.
First phase: There is a sharp initial fall that removes much of the ‘froth’ from the market.
Middle phase: There is a strong rally in prices for several months, which may lull some investors into thinking that the bear market is over. The rallies can be dramatic, but have lower trading volume than the initial sell-offs. And the advances tend to be concentrated on a few selected stocks, not the whole market.
Third phase: There is a long slow downward grind in prices, accompanied by low volume and periodic false dawns until the bear phase ends quietly as share valuations reach rock bottom. At this point, few investors from the earlier buoyant phase in the market are interested in anything other than the most conservative investments.
As seen from history, once started, bear markets rarely finish without at least a 40% decline in prices from the previous bull market peak. Often it is substantially more than this, sometimes as much as 80% or 90%.
How bear markets end
Stock markets are driven by fear and greed. Just as the top of a bull market is marked by a climate of greed and exuberance, so the bottom of a bear market is marked by a climate of fear and pessimism.
But this has to end sometime, and in the past there have been a number of key signals that have indicated the beginning of the end:
Indiscriminate selling after a long period of slowly declining prices
This is sometimes called ‘capitulation’. Investors dump stocks at any price and vow never to return to the market again.
A major potential corporate or political crisis, particularly if it has ramifications for more than one company or market
Highly negative but irrational rumours about companies
Low stock market ratings
It is common for solid blue chip stocks to be valued on single figure price earnings ratios at the bottom of a bear market.
Low real interest rates and the beginnings of a downtrend in bond prices
Low real interest rates are a precondition for economic revival, but a reviving economy means that inflation may again begin to increase, which is bad for bonds. Because of this and the prospect that interest rates may eventually rise as the economy picks up, the start of bull markets in shares is usually signalled by an opposite reaction in the bond market.
Think of the markets as a pendulum. The pendulum swings from bull to bear, overshoots, and eventually swings back.
I understand that this was a bit theoretical, but that was the whole purpose. To make every reader aware of the basics of bear market and its behaviour. It is almost impossible to wriggle out of a bear attack without understanding its strength and weaknesses properly.
In my next post on bear market i’ll deal with more intricate and practical parts of bear market and investment strategies to follow, detailing down to type of stocks, market cap of stocks, cash management strategies, other asset classes and investment psychology to adopt.
Till then stay blessed. Bulls will be back soon!