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Wall Street’s Animal House
Explaining Bull and Bear Markets
When the stocks in your portfolio begin to climb in value, what’s your first thought? If it’s “What should I buy next?” you have a glimpse into what fuels a bull market. When investors are rewarded with rising prices — and are confident they can choose winners — they tend to buy more. That demand drives prices even higher, confirming their expectations and boosting their optimism. Strong returns, in turn, draw more investors as more money flows into the market.
But that’s not the whole story, of course. Every bull market runs out of energy sooner or later, though it’s impossible to predict the precise moment that will happen. Many factors may contribute to a downturn. Corporate earnings may be weaker than expected. Interest rates may be rising. An important sector of the economy or a vital overseas market may have stumbled. But the result is always the same: Pessimism replaces optimism. You sell some of your stocks, and so do other investors.
Soon supply exceeds demand. Prices drop, sometimes gradually losing steam over several months and sometimes falling dramatically. Prices may fluctuate for a while or steadily drift lower, but when a major benchmark index such as the Standard & Poor’s 500 or the Dow Jones industrial average falls 20 percent below its 52-week high and stays there, it’s a bear market.
Like a bull market, a bear market also runs its course and the cycle starts over again — or at least it always has. Sales and earnings pick up, investors venture back and prices start to rise. Sometimes the full cycle — from one peak to the next — lasts months, sometimes years. It’s hardly surprising that the deeper the drop, the longer the climb back. When the DJIA lost 89 percent of its value in the bear market that ran from 1929 into 1932, it took until November 1954 to recover its former high.
Bull and bear markets are recognizable, in retrospect, because the market’s direction maintains an overall up or down course despite plateaus called ranging markets. These are extended periods during which prices move sideways rather than gaining or losing very much.
Hindsight also makes clear the extent of the upward or downward trend and the precise date at which the market turned. Oct. 9, 2007, for example, marks the top of the most recent bull market.
Sometimes what seems at various points to be signs of an overall shift in direction turn out to be relatively short interruptions. The long bull market that began in 1982, for example, survived the stock market crash of 1987, major losses in 1997 and 1998 and a number of less dramatic corrections before it peaked in January 2000. A correction is a temporary downturn, typically involving losses of more than 10 percent but less than 20 percent that are erased as the bull market resumes.
Similar interruptions occur in bear markets, but curiously they tend to be described in more colorful terms. Bear traps are baited by sudden, brief upturns that suggest the market is turning around. And a big increase after a particularly steep sell-off is described as a dead cat bounce.
Why are roaring bulls and growling bears something you need to know about? One reason is to keep out of their way — or more precisely, to prevent them from interfering with your long-term investment strategy. That may be easier than it sounds: The optimism that drives bulls is contagious and the pessimism that trails bears is sometimes downright scary, especially as your account value erodes.
There’s no question that investors get hurt, both by buying high as the market peaks and selling low as it collapses. Of course, sometimes selling to prevent even greater losses is prudent, especially if a corporation’s fundamentals collapse. But selling simply to get out of the market is almost never a good idea.
Investors get especially hurt in a bear market when their portfolios aren’t broadly allocated and sufficiently diversified to help spread out their risk. A combination of fixed income and equity may not prevent portfolio losses but can soften the blow, especially if you own domestic and international stocks with different market capitalizations and different reactions to market cycles.
Depending on your investing strategy, you may in fact be able to capitalize on market downturns.
For starters, if you’re using dollar-cost averaging — also called a constant dollar plan — to build your portfolio, continuing to add money to your account in a downturn will let you reduce the average price you pay per share below the average cost per share. That’s because you’ll be buying more shares with each purchase. But if you stop investing when the market drops, that advantage disappears.
Your continuing research should also help you identify stocks whose prices have been battered but whose fundamentals are strong. If you invest before the market turns around, you’ll be in a position to benefit from the rebound. You have to be prepared, though, for prices to drop more after you buy, since there’s no way to pinpoint the bottom before it happens.
It takes discipline and careful planning to buy successfully in a bear market. But the bigger question often is whether to sell your winners in a bull market. If you’re a committed buy-and-hold investor, the answer may be no. There are solid reasons for that choice, especially if the stocks are in a taxable account. But there’s also an argument for judiciously taking profits, perhaps by selling a portion of your holdings in stocks that have outperformed your expectations, with the thought that you may well buy those stocks again when their prices correct.
So not all is lost in a bear market, especially if you stick with your strategy, act prudently and don’t panic — which only encourages a bear.
Virginia B. Morris is the Editorial Director for Lightbulb Press.