Phases of a Bear Market

In analyzing US bear markets dating back to the early 1900s and reflecting on managing client wealth through the bear markets of 2000 and 2008, I can see that there are some very similar phases of a bear market. Not all bear markets are alike, but they all have similarities. Typically bear markets have five phases. I will outline the five phases and give you some indication on what to expect during each of these periods. We appear to have concluded phase one of this bear market last week, and have four more phases left before it concludes. There are factors over the next few weeks (involving the Federal Reserve) that could change the market from a confirmed bear market back to a bull market, but, at this point, we are underweighting equity exposure until we see how the economy fares over the next few months.

The Phases of a Bear Market:

Phase 1: The Warning Phase: I have discussed this phase on past writings. Typically in the warning phase the stock market drops between 7-13%. Phase 1 of this bear market fell a little over 14%, so a little strong in comparison to other bear markets. What makes this correction different than those of the past six years is that in February we experienced a change of pattern and set new lows in almost every index from the previous correction (August 2015). During the warning phase, all investors get nervous and start to question their investment strategy.

Phase 2: The Denial Phase/The Dead Cat Bounce Phase: During this phase (which I believe we are currently experiencing), the stock market has a significant multi week rally that is swift. The indexes typically get back about 70% of the loss. If this occurs over the next month, the DOW could get back above 17,000. Analysts on Wall Street (who are always bullish) reiterate a bull market in stocks and call for new records on the DOW (which Citi bank called for last Friday). These analysts (most of whom do not manage money) fail the most here in anticipating a declining economy ahead. From analyzing past bear markets, Phase 2 proves to be the best time to reduce equity risk, if you have not taken steps prior to the initial decline. Currently, I see Phase 2 (our current phase) lasting through February and potentially through March.

Phase 3: The Acceptance Phase (“It’s a bear market”): During this phase the market starts to show real economic concerns. Unemployment typically starts to rise; banks start to have problems, etc. This is the most emotional phase of a bear market. Some bear markets are mild (-25%), some are not so mild (-50%). During this phase most of the loss is realized, because investors typically sell at the bottom of this phase. This phase of the bear market is the longest phase, and can last for many months (the average for the past two bear markets has been six months). Wall Street starts to move away from its bullish stance on the market but will still express to investors that buy and hold strategies are prudent. For patient investors that reduced prior to the start of the bear market, there are some nice opportunities at the conclusion of this phase.

Phase 4: “The Bear Market is over” Phase/A Second Dead Cat Bounce: During this phase the stock market rallies stronger than Phase 2 due to the nature of the correction that is experienced in Phase 3. During late 2008, the DOW Jones rallied over 500 points a day on a few occasions. Many Wall Street firms start to claim that a new bull market in stocks has started and that the bear market is coming to an end.

Phase 5: Capitulation Phase: During this phase the stock market experiences its final selling. Depending on the strength of Phase 3, this phase can be strong, or this phase can be mild. In 2002 this was mild; in 2009 it was strong.   During this phase Wall Street is known to finally give in and warn clients of lower prices ahead.  During this phase in 2009, many firms forecasted the DOW to drop to 4,000 prior to the end. It bottomed during this period at 6500. Historically bear markets bottom when the PE ratio of stocks drop to around 7. That hasn’t been the case the past 30 years, but it is the norm.  During this phase, you have your best stock market opportunities, and they will only come around a few times in your lifetime. These are rare opportunities; at the bottom in 2009, CBS was below $3, and Apple was below $15 a share.

I kept detailed notes of what happened in 2007-2009. I see that market as a blessing as I was able to detach myself from the news and become a technician. For the past four years I have been very bullish on stocks; I started to move to a neutral stance in November of last year when the market failed to get back to key markers and then to a bearish stance in January. I will end this with a piece from my notebook I kept regarding the 2007-2009 stock market (about which there is a movie called The Big Short in theaters today):

In October of 2008 Warren Buffet bought stocks. The DOW was at 8500. When the market went further down in the first quarter of 2009, Mr. Buffet was questioned on CNBC about his “wrong purchase”. Warren answered, “I don’t know when the top or the bottom is, I just know I am closer to the bottom than the top”. Three years later when the DOW was at 12,000, many had forgotten his lesson.

Our internal research suggests we are still early in the 2016 bear market. If you would like to discuss how the bear market will affect your investment portfolio, send us an email or give us a call at 317.428.6600,