The Anatomy of a Bear Market

27 Mac 2022

Recently, a lot of people have been talking about the possibility of a multi-year recession. I don't think that is a clear depiction of the current situation, but I am aware that the idea stems from a lack of understanding of bear market structures, and influence of market sentiment. So in this post, I'll be going over Ken Fishers' rules and conditions that must be met in order for a market to be clarified as a bear market, and how you can best position yourself to minimize downside risk.

This is not financial advice. This is for educational purposes only.

The Four Rules of a Bear Market
- The first rule is the two percent rule: a bear market typically declines by about 2% per month.
- Sometimes it declines by more than 2%, sometimes it’s less—but overall and on average, bear markets don’t often begin with the sharp, sudden drop some anticipate.
- If a bear does drop by more than 2% per month, there’s often a market counter-rally that can provide better opportunities for investors to sell.

- The three month rule: This rule advocates waiting three months after you suspect a peak has happened before calling a bear market.
- Rather than trying to guess when a market top might come, this rule ensures one has passed before taking defensive investment action.
- It provides a window of time to assess fundamental investment data, market action and possible bear market drivers.
- I often see lots of people call market tops and bottoms, and time the market perfectly, but it needs to be clearly understood that this isn't the right approach to understanding the market.

- Next, we have the the two-thirds / one-third rule.
- About one-third of the stock market’s decline occurs in the first two-thirds of a bear’s duration, and about two-thirds of the decline occurs in the final one-third.
- This was the case in the bear market caused by the financial crisis, as well as many other bear markets including that of 1973.
- Combining this with the three month rule, it also implies that if you have identified that a market has indeed begun its bear run, you might be better off taking profits/losses on your position, managing risk by increasing your cash holdings, and buying back when capitulation has happened.

- And finally, we have the 18-month rule.
- While bull market durations vary considerably, statistics demonstrate that the average bear market duration, since 1946, has only been 16 months.
- Very few in modern history last fully two years or longer.
- If you’re engaging a defensive investment strategy, you probably shouldn’t bet on one lasting so long.
- The longer a bear market runs, the more likely you’re waiting too long to re-invest.
- If you remain bearish for longer than 18 months, you may miss out on the rocket-like market ride that is almost always the beginning of the next bull run.
- Missing that can be very costly for investors.

So are we currently in a bear market?

- Based on the four rules above, there's a high probability that we are not in a bear market.
- Since I've uploaded this post, the market has bounced swiftly off the 100 moving average on the weekly.
- Just as the covid-induced drop of March 2020 turned out to be a 'buy the dip' opportunity, as opposed to the beginning of a bear market, the sharp correction we have seen since the beginning of this year goes against the first rule of the bear market.
- It’s critical not to call a bear market falsely, and this is a huge mistake that a lot of people make.
- If the market is just going through a correction (a short, sentiment-driven downturn of -10% to -20%), you’re better off riding through it and maintaining your portfolio.
- It is impossible to accurately and consistently time market corrections because of the way they behave.
- A correction can start for any reason or no reason. So if you believe that the economy is strong, and the fundamentals of the company you invest in remain solid, there's no need to sell off your holdings, especially when your actions are motivated by fear.

Conclusion
Bull market corrections are not fun, but it's important as an investor for you to be able to distinguish bear markets/recessions from bull market corrections. Choosing to undertake a bear market investment strategy and go defensive should be rare and shouldn’t be done by gut feel or by your neighbor’s opinion. Exiting the market is among the biggest investment risks you can take—if you’re wrong and you have a need for portfolio growth, missing bull market returns can be extremely costly.

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