What Makes A Bear Market?

  • Post category:CME Updates

The most commonly held definition of a “bear market” in stocks is a 20 percent price decline from peak to trough. Although there are several different index’s one could use to measure, most often people are referring to the Dow Jones industrial average or the S&P 500 index.

Traders tend to look at the S&P 500 because it’s far more broad then the Dow 30 and less volatile than the technology heavy Nasdaq 100.  Since 1999 there have been three bear markets in the S&P 500.  All bear markets are definitely not created equal. The “tech wreck” of 2000 and the real estate implosion of 2007 were vastly larger than the minor 2011 bear caused by the European crises. The main reason that bears differ is that the bull markets that precede them are often unique.

Story, Sentiment and Market Position

Prices of any asset are determined by three things: the story, the sentiment and market position.  The story refers to the fundamental drivers. In stocks things like an improving economy, growing consumer demand, new technologies and low interest rates can all contribute to a bull run.

The sentiment refers to a spreading belief that if you don’t buy soon you can miss the run.  We saw this play out in real time over the last year as bitcoin went from an interesting new technology to the gotta have it asset and then back to… well you get it.

The market position part of the equation tends to be a more elusive concept to average investors. Simply put this means that sometimes prices reverse lower because all the potential buyers are already in and there’s no new money left. The classic story about Joe Kennedy selling all his stocks because the kid who shined his shoes was investing in stocks underscores this point.

Historical Asset Bubbles

The larger two bear markets we have seen in the last 20 years were preceded by an obvious asset bubble. When I use the word “obvious” some may bristle, but in my circles many knew it was a bubble but no one knew when it was going to pop. These bubbles were fueled by all three price influencers firing off in unison for an extended period of time.

The new technologies of the internet and the perceived one-way price path of real estate lulled investors into believing that the bull would never stop.  The fervor culminated in ordinary people mortgaging everything they owned to buy tech stocks and investment properties.  Once everyone was on board things changed. Sentiment went from wildly bullish to wildly bearish and everyone raced for the exits. The next stage was forced selling from margin calls.

The devastation didn’t stop until the S&P was down 51 percent after the 2000 bear and 58 percent after 2007.  The bear market of 2011 was far more shallow because the fundamental shift did not come at a time when sentiment and positions were at elevated levels.

Did We Have a Bear Market in 2018?

So how do these examples compare to the current situation? In 2018 we have had two pullbacks of greater than 12 percent. In assessing the possibility of these moves morphing from a garden variety correction into a bear market, we have to ask a few questions.

Has the fundamental picture changed?  Yes. Interest rates have risen and now are competing for money that previously would have been funneled into stocks. Trade relationships have also come into question and these ramifications are still an unknown.

Has sentiment changed? Yes. I believe we’re in an atmosphere where fear and worry seem more dominant. I offer as proof the elevated levels of options volatility priced into CME options on equities.

Is market position at a point to fuel a massive move lower? No. The run up that preceded our current market weakness seems far more reminiscent of 2011 than it does of either of its two big brothers.

So yes, there are plenty of things to worry about in our current state. Yes, a bear market is a possibility. Every bear market, however, doesn’t turn into the dramatic environment we’ve seen twice before.

The post What Makes A Bear Market? appeared first on OpenMarkets.

Source: CME Open Markets – What Makes A Bear Market?