A bear market is distinguished by a period of at least two months of declining stock prices that leads to a falling total stock market value as a result of a declining investor confidence. As investors do not trust the market, they massively sell their holdings. This strategy causes multiple losses in major indexes. As the losses grow bigger, investor confidence declines further till the stock market crashes.
A bear market usually follows an economic recession with high inflation that slows down further economic growth. Unemployment rate is high and consumer spending is low as consumers lack the money to buy basic goods. In such an economic environment, the stock market portrays investor panic and declining investor/consumer confidence.
The typical causes of a bear market can be summarized as follows:
1. Consumer confidence
Consumer Confidence can significantly influence the stock market. If people do not feel confident about the economy in general, they spend less. Money can be tight as a result of austere fiscal and monetary measures. Nevertheless, declining consumer spending has an adverse effect on corporate profits and share prices. If good news about the economy are out (e.g. lower unemployment rate), the feeling changes and people are more confident about the economy, so they spend more, thus increasing corporate profits. This has a favorable impact on share prices.
2. Consumer spending
Consumer spending is directly related to consumer confidence. When people are confident about employment and money, they borrow lower, they spend more and they invest in the stock market, causing the market to rise. On the contrary, when consumers are not confident about the economy, they save more, they spend less and they don’t invest in the stock market, causing market shares to decline. Declining consumer spending can significantly restrict the growth of the money supply in the market due to lack of liquidity. Typically, savings or spending habits may provide an insight for corporate profits.
3. Corporate debt
It is not a secret that corporate America is in full debt. Big corporations raise capital by borrowing cheap (debt financing) instead of issuing additional shares (equity financing). Yet, in tough economic times, keeping up with debt is quite difficult for companies that have already raised billions in debt financing. Often, large corporate debt has an adverse impact on consumer confidence, causing the stock market to decline.
4. Interest rates
Rising interest rates have a devastating effect on consumer confidence. When interest rates are on the rise, consumers do not feel comfortable to invest in a highly volatile stock market. Even if the interest rates reach their historic lows, they are typically followed by an interest rate spike that has an adverse effect on consumer confidence and share prices.
5. Overvalued stocks
Often, stocks are overvalued in order to entice more investors into buying. However, stock prices should be determined based on corporate earnings rather than on P/E ratio. Otherwise, valuation of stocks is not accurate and investors may incur huge losses.
All in all, when consumers are spending, companies are profitable. And when companies are profitable, share prices are rising because investors feel confident about the economy and trust the financial markets with their money. This sequence of factors eliminates the occurrence of a bear market.