5 Reasons Investors Should Learn to Love Bear Markets
Investors are conditioned to fear the bear, but this simplistic thinking can lead to major investment mistakes.
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In the investment world, the terms "bull market" and "bear market" are used constantly. They are really just shorthand ways to indicate whether the market is strong or weak. There are formal definitions for these terms, but the labels are primarily used because they make it easy to write headlines and make general statements about market conditions.
Quite often, the action in the indexes does not reflect what is going on under the surface in individual stocks. There are always individual stocks and sectors that move contrary to the overall market trend, and most of the time, the business media fails to cover this very well.
If we look at just the times that the market has met the formal definition of a bear market — which is a drop of 20% from highs — there have been 27 bear markets in the S&P 500 since 1928. The average decline during these bear phases is 35.62%, with an average duration of a little over nine months. On average, the S&P 500 has fully recovered and reached its prior highs in about two years. Bull markets tend to last about 2.6 years and produce an average return of 169%.
Most long-term investors are counseled to sit tight during these bear markets, which makes sense. Over the very long run, bear markets are largely irrelevant, however. A $100 investment in the S&P 500 in 1926, with dividends reinvested, grew to $1.48 million by 2024, despite 27 bear markets. This is a compounded annual return of 10.3%.
Investors are conditioned to fear bear markets and celebrate bull markets, but this simplistic thinking tends to lead to major investment mistakes. The emotions that arise during bear markets often drive investors to panic at the worst possible times and to make many other strategic mistakes.
The reality is that whether a bear market is a bad thing or not depends on how you deal with them and how you think about them. Bear markets are inevitable. There will always be cycles of ups and downs in any market, and understanding and embracing that fact will help you produce exceptional returns.
Five Primary Reasons to Celebrate Bear Markets
There are five primary reasons to celebrate bear markets.
1. Mispricing creates new opportunities. Bear markets are the way that excesses in valuation are corrected. The Dot-Com Bubble Burst in 2000-2002 is probably the best example of this. Many stocks were valued based on metrics such as page views and internet traffic that had little to do with actual revenues. Many of these stocks were wiped out completely and never recovered. However, the entire market was dragged lower when the bubble burst, and many very good stocks became exceptional values. It took a long time for the market to shake off the distortions that the internet bubble produced, but there was a multiple-year rally until the Great Recession Bear Market in 2008-2009 and then a major bull market run of over 12 years before the Covid bear market hit 2022.
2. Better stock picking. When bear markets hit, the selling tends to be at the index level. When the Nasdaq 100 ETF QQQ is sold, all 101 stocks in the index are sold as well. Many of these stocks still have very attractive valuations, but that doesn’t matter when the market is in the jaws of a bear market. Eventually, these stocks will be discovered again, and they tend to outperform when the bear market comes to an end.
3. Enhanced volatility creates short-term trading opportunities. The biggest market rallies tend to occur in the worst markets. Big drops are inevitably followed by big rallies. For short-term traders, these counter-trend moves can provide exceptional returns if they are timed correctly, but it is not easy. A good trader can do well in bear markets by trading only counter-trend moves if they stay vigilant and can move fast.
4. Opportunities to lower cost basis in favored stocks. For longer-term investors, bear markets are an ideal time to add to favored positions. This is basically the Warren Buffett approach. As long as there is no major change in the fundamentals, Buffett-type investors want to take advantage of lower values. The goal is to own with the lowest possible cost basis and then stay very patient for a very long time.
5. The ability to produce relative performance. For professional investors, the most important performance metric is how they are doing compared to a benchmark index such as the S&P 500. If you are beating the indexes — even if you are losing money — then you are a success. Beating the indexes is very tough when there is a strong uptrend. It is much easier for professional investors to outperform by losing less money in a bad market. Hedge funds make their money not by producing better returns in bull markets. They make their money by producing better returns in bear markets. Bear markets often make it easier for astute traders to outperform by a substantial margin.
The key to dealing with bear markets is to approach them with a positive and optimistic mindset. It may be unpleasant to see your accounts drop in value, but if you maintain some level of flexibility, then you should focus on the opportunities that are being created. Too often, investors are frozen into inaction, and rather than focus on opportunities, they rack up big losses and then sell when the misery becomes too great.
No one knows when the next bear market will hit, but my best advice is to not fear them but look forward to them as potential opportunities. Think about how to prepare for those opportunities by staying flexible and nimble.
At the time of publication, Rev Shark had no positions in any securities mentioned.
