Don't fall for the bear market rally! Do this to protect your money in the stock market crash instead!
We’ve been stuck in a cycle of bear market rallies all year, the ultimate market head fake where stocks start to recover only to fall back down into that longer-term bear market.
In this video, I’ll explain the bear market rally, show you what it is and how long they usually last. We’ll look at average time the market stays in a bull and bear market and what causes stocks to fall. I’ll then give you a complete plan for how to invest in a bear market, avoid these kinds of bear market traps and what to do.
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What is a Bear Market?
I want to start with the basics of a bull and bear market in stocks, what causes bear markets and how long they last. Then we’ll look at the bear market rally and how to invest without losing your money.
The technical definitions of a bull and bear market aren’t very helpful. A bull market is when stock prices are increasing over more than a few months while a bear market is any drop in a stock or the market of more than 20% from the peak.
Clearer is the levels of investor sentiment and thinking we see in bull and bear markets. During the bull market, investors transition from hopeful to optimistic and overjoyed as stocks keep heading higher. Everyone is going to be rich and the market will never fall.
In a bear market, that remaining hope quickly fades as denial sets in then bargaining and panic. It’s actually a lot like the seven stages of grief, ending in capitulation and despair when investors finally give up.
How Long are Bear Markets?
Looking at this research from Mackenzie Investments, we see there were 12 bull markets over the 60 years to 2020. On average, stocks jumped 129% from the low point to the bull market top and lasted about 54 months.
There’s also been 12 bear markets of a 20% drop or more with stocks falling an average 28% when the bull stops charging and it’s taken an average of nine months from the peak in prices for the market to find a bottom.
Now it’s true that history never repeats and no two bear markets are alike but when Twain said history does tend to rhyme, he could have been talking about stocks because there are common causes to bear markets and recession.
If we look back on the eight major market crashes since ’56, we do see some common causes. Higher interest rates is the most common, often after a run of high inflation. A few times, some kind of geopolitical event has caused a commodity price shock that helped feed into inflation. Lately we’ve also seen crashes followed by three- to five-years of runaway stock prices as well.
So what happens in a bear market rally and why is this the ultimate head fake for investors? First though, I want to get your opinion on this. How long do you think the current bear market will last? Scroll down and let me know in the comments, how long will stocks keep falling and what level on the S&P 500 will we reach at the bottom?
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What is a Bear Market Rally?
A bear market rally, or bear trap, is a short-term rebound in stocks usually five- or ten-percent higher before the market starts falling again to reach lower lows.
Looking back on the Nasdaq, you can see we’ve already had three of these this year with the market up as much as 16% in March before falling back and hitting that May low. We also started a rally in late May that looks like it’s unravelling already.
So with the average length of the whole bear market around nine months, these bear traps usually average from two or three weeks to as long as a couple of months. And that’s what is so frustrating about these is some can last long enough to make you think we’re back in a bull market with stocks heading higher, only to fall back and lose more money.
What Causes a Bear Market Trap?
These bear market rallies are often caused by short-term oversold conditions and anxious investors still trying to buy the dip but before any real change in the fundamental market forces pushing stocks lower.
For example, in a chart of the S&P 500 with the Relative Strength Index or RSI graph. That’s a technical indicator that measures momentum in prices to indicate if stocks might be overbought or oversold on short-term trading. And we see that before each of the bear market rallies this year, the RSI has approached and even broken below the 30-level that indicates oversold conditions.
Basically, stocks fall so fast and investors get so negative that the market is like a coiled spring, ready to bounce back higher. Prices head higher for a day or two on that relief rally, investor sentiment improves as more investors try to buy in on the rebound and you get a bounce of five or ten percent.
The problem is, nothing has really changed in the market or the economy. The bigger picture that was forcing stocks and investor sentiment lower is still firmly in focus; in this case interest rates that are likely to rise for another year, slowing the economy, and decades-high inflation that is starting to weigh on consumer spending.
So once the market lets off a little of that tension, stocks are no longer oversold, and some economic data is released to remind investors of those downward forces, the bear market takes over again and stocks hit new lows.
The dangerous part in all this is the rallies pulls investors back into stocks, fearing that they’ll miss out on the next bull market, and they push all their cash into the market. When stocks head lower again, investors are stuck with nothing to do but watch their portfolio shrink.
How to Invest in a Bear Market
We’ve already seen that a new bull market cannot start until those bigger picture fundamentals and the economy starts to change. For example, we likely won’t see the bottom in stocks until some signal that the Fed is ready to stop raising rates and that won’t happen until we see inflation come down below five-percent and keep falling. Until that point, any rally in stocks is probably going to be a classic bear market trap, so how should you invest?.
First, if the stock crash is causing you to lose sleep and you haven’t built a cash cushion to invest later, bear market rallies can be great opportunities to de-risk a little and build cash. Now that doesn’t mean you rush to sell all your stocks as soon as the market goes up five-percent. Instead, look through your stocks and pick out any that aren’t high confidence, long-term investments. These are going to be your highest level of stress in a market crash because you’re on the fence about owning them in the first place.
What you can do is the next time the market rallies 5% then consider selling a third of your position in these. If the market continues to rally up to 10% higher then maybe sell another third of your original position. You can also sell in-the-money call options against some of the position if you don’t want to sell but the idea is, you take some risk off the table and convert that into cash. You still have some money in the stock as well as the rest of your portfolio so you benefit if stocks do keep rising, but you’ve also lowered your risk and now have some cash you can invest later if the bear rally falls apart.
Another strategy you can use is called the barbell approach. If you think of a barbell, you have all the weight on each end and nothing in the middle. With a portfolio, this means you would have your investments split with about half in high-risk stocks and the other half in extremely safe assets like cash, the Series I Savings Bond and short-term bonds like the Vanguard BSV Fund.
What this does, it gives you the opportunity to benefit when the market recovers because it’s going to send those oversold tech and growth stocks booming higher. When the S&P 500 rallied 10% in the March rebound, shares of Tesla surged 49% in just two weeks. Having the other half of your money in those extremely safe investments though gives you the opportunity to protect that part of your portfolio and buy into stocks at lower prices if the bear market continues.
Understanding what happens in a bear market rally will help you avoid the same trap so many investors fall into when the stock market crashes. Watch for the sudden rebound in stock prices with no change in underlying fundamentals and be wary of the trap. Invest longer-term to protect your money!
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