Bear markets are naturally unpopular: people dislike seeing their investments go up in smoke. They are also misunderstood. It is commonly believed that bear markets are short-lived, ending after a few unpleasant months. That's true of little bears, but great bears can hang around for a decade or more. They are characterised by the savage crushing of investors' hopes. Most commentators argue that British and US investors hadn't until very recently experienced such a market for more than quarter of a century. Actually, we are already some years into one.
A bear market is classically defined as occurring when a stock market index declines by 20 per cent or more from its previous peak. If you take this narrow measure, America and many other major markets recently entered a bear market—the US in early July. Yet this accepted definition is misleading—applying only to little bears and not their much more terrifying great bear kin. Andrew Smithers of research firm Smithers & Company argues that "bull" markets should be seen as periods when stocks become ever more expensive. By contrast, bear markets are when stocks become progressively cheaper. Since 1900, the US stock market has peaked in value five times. The period between the peak and trough—the great bear market—lasts on average 12 years, says Smithers.
During these quarter-century cycles, there are many times when share prices have oscillated by more than 20 per cent from their prevailing trend—whether up or down. But these little bears are just blips in longer market trends. For instance, US equities fell 27 per cent during the so-called "Kennedy break" of 1962. But this only momentarily interrupted the long bull market that ran nearly two decades from 1949. Nor did the crash of October 1987 usher in a great bear market. After surviving several assaults, the long bull run that commenced in August 1982 finally expired in early 2000.
The grim downward progress of the great bear is invariably interrupted by rallies. These may be brief, such as the classic "sucker's rally" which occurred after the Federal Reserve bailed out Wall Street in March 2008. Or they can last years. For instance, the great US bear market of 1968 to 1982 was punctuated by a big rally between 1971 and 1972 when investors became infatuated with the "nifty fifty"—a select group of American companies, such as Polaroid and Coca-Cola, that were thought to have superior growth characteristics. But with the passage of time, we are able to discern a single great bear market lasting nearly 14 years rather than a series of mini bull and bear runs.
When the technology bubble burst in March 2000, US stock prices were more expensive than at any time in history. The bursting of the tech bubble marked the advent of another great bear market. As with the "nifty fifty," there was a rally starting in late 2002 as Alan Greenspan at the Fed flooded the financial markets with cheap debt. The S&P 500 index even reached a new high last year despite the sub-prime debacle and the emergence of a full-blown credit crunch. Yet history is likely to judge this rebound as yet another bear rally.
Great bear markets have common features. They start at moments of extreme valuation—the collapse of Japan's bubble economy in 1990 occurred after a period where the prices of shares and land reached crazy levels. At one point, the Imperial Palace in Tokyo was purportedly worth more than all the real estate in California. The peaks of great bull markets are also characterised by a belief in new eras and the ability of the authorities to deliver perpetual economic growth and stable consumer prices. During bear markets, this faith evaporates and is replaced by growing mistrust.
Stocks tend to become seriously undervalued when consumer prices become unstable, undermining faith in paper financial assets. Deflation drove US stocks to their troughs in 1921 and 1932, and fear of deflation produced another low ebb in 1949. In the 1970s it was inflation that was the enemy. Great bears often have an international dimension. The whole world was in depression in the early 1930s. The US stock market collapse of 1974 was accompanied by the failure of Germany's Herstatt Bank, Britain's secondary banking crisis and Opec pushing up the global price of oil.
So what marks the end of a bear market? Investors are naturally emboldened by an end of any financial crisis. Most important are signs that the authorities have succeeded in their battle against either inflation or deflation. Paul Volcker's defeat of inflation was the prelude to the bull market that started in 1982.
Our current bear is little more than eight years old. That's roughly two thirds of the lifespan of the average great bear market. Until recently, there had been no disturbance to consumer prices to drive equities down to low valuations. That is no longer the case. Following the credit crunch and the subsequent cut in US interest rates, there are two opposing threats to price stability. On the one hand, there is a risk of deflation following the loss of nearly half a trillion dollars worth of bank capital around the world—with more to come. On the other hand, there is danger of inflation, which recently drove oil to around $145 a barrel (although it has fallen recently). As for valuations, according to Robert Shiller at Yale, US stocks remain overvalued at roughly 40 per cent above their long-term average. In 1982 they had been trading at below their long-term average for eight years. If history repeats itself, valuations will have to fall a long way before this great bear slopes off.
