Bearing up

This lesson is equally true whether we're talking about brown bears in a forest or bear markets in equities. The latter can inflict vicious damage on your investment portfolio, which could be deadly if you're close to retirement. Knowing and understanding the beast is essential to coping in these situations.

What is a bear market?

A bear market is usually defined as a fall in a stock market index of 20 per cent or more. Smaller drops are usually labelled as corrections of varying degrees. Of course, this is merely a rough rule of thumb. Just because a market falls "only" 19 per cent and doesn't quite qualify as a bear market won't cheer an investor who's suffered a substantial drop in portfolio value.

According to Dow Theory - a branch of technical analysis - a 'primary' bear market occurs when an index drops below its last 'secondary' low. For instance, in July and August 2007, the FTSE 100 experienced a downwards correction against its larger, upward trend, which took it down to 5822.

The UK's main index then rallied back up almost to its previous highs in November and then dropped to 5339 in January. Because that move breached the prior secondary low at 5822, the primary trend of the market is said to have changed from upwards to downwards.

So are we in a bear market now?

According to Dow Theory principles, the FTSE 100 registered a bear market when it dropped below 5822. The primary trend will continue to be classified as downwards until the index makes a high above 6754.

By definition, the FTSE 250 index - which is made up from medium-sized firms - is in a clear bear market. From peak to trough, it has dropped 27.5 per cent.

How long do bear markets last?

History is probably the best guide to where this bear market could take us. This bear market has already lasted more than 160 trading days. But really prolonged bear markets can last a great deal longer. Thankfully, bear markets appear to have become rather shorter in the modern period. Nineteenth century bear markets were frequently multi-year events.

The table below gives you an idea of how long various bear markets have lasted.

Would a US recession cause a UK bear market?

Since 1945, there have been 11 recessions in the United States. Six of these have occurred in similar time frames to bear markets in the UK. The tendency for the UK to suffer a bear market around the time of a US recession may have strengthened over the years. Four of the five post-war US recessions when there was no bear market in the UK took place in 1960 or before.

The stock market is, of course, a forward-looking mechanism. Therefore, we would logically expect bear markets to precede recessions and to end before the recessions do. Experience bears this out. With one exception, every single post-war UK bear market coinciding with a US recession started before the US recession began and ended before the US recession ended. On average, UK bear markets have started five months before a US recession and they've tended to end about four-and-a-half months before the corresponding US recession ends.

Are you better off with value or growth shares in a bear market?

There's a belief that 'cheap' or 'value' shares are a better bet during a bear market than more expensive growth shares. Intuitively, we might expect growth shares to have higher betas than value shares and therefore for them to fall more when the market does. In reality, though, things aren't as clear cut as this.

Looking at the MSCI UK indices, we can see that in the six major UK stock-market corrections since 1976, honours are even between value and growth. During the current sell-off, growth has taken a commanding lead over value.

Growth's decent showing during bear markets could have something to do with economic weakness. While they don't overlap precisely, bear markets are often associated with recessions, or at least a weak economy. Such periods tend to see falling interest rates, which are beneficial to growth firms. A lower discount rate increases the present value of their future cash flows more dramatically than for value firms, and hence justifies a higher share price.

How do other assets do during equity bear markets?

As we've seen, shares generally do badly in absolute terms during bear markets. Some sectors and individual issues do better than the rest, but usually only in relative terms. However, there are plenty of options outside of the stock market to protect and grow your wealth.

The most obvious thing to hold is cash. A savings account should yield a positive nominal return via the interest rate paid. And you're pretty much guaranteed that your underlying capital will remain safe. Cash may sound unimaginative, but it really comes into its own during a prolonged slump. In the 2000-03 meltdown, £1,000 invested in the FTSE All-Share would have shrunk to about £550 - even with dividends reinvested. By contrast, £1,000 in cash would have grown to about £1,185.

A more interesting alternative would be to hold your savings in a foreign currency. The Swiss franc has risen in every UK bear market or correction since 1965, except once where it only fell by 1.5 per cent. Its average annualised gain during these periods is 13 per cent. But we're being conservative here and assuming no interest received on the deposit. Adding this on would clearly make things more attractive still. The euro seems to work just as well for this purpose; see the table below (of course, the euro wasn't around in 1966 - we've used its precursor, the Ecu, as a proxy).

Another asset that may do well while the UK market suffers is property. On only one occasion since 1965 have nominal house prices declined significantly at the same time as UK equities. Unfortunately from the perspective of today's investors, that occasion was 1990, a period that rather resembled the current situation.

Gold is famed for its protective ability in times of worry. The historical record bears this out. In every correction since 1979, gold has risen in absolute terms when UK equities have fallen. In the current environment - where inflation is once again a major fear - gold is likely to continue performing its traditional role.

How do we know when we're near the bottom of the bear market?

You need to be long-sighted when it comes to calling the bottom of bear markets. The news will inevitably look hideous just at the time the stock market turns up from rock bottom. The headlines will be full of gloomy talk about ongoing economic weakness, with job losses and falling profits. After long and savage bear markets - such as that of the mid-1970s or 2000-03 - equities are a word not uttered in polite society.

Such things are fairly imprecise indicators of the bear's demise. We can also look for signs of capitulation in momentum oscillators. A simple technique is to see how far the market is trading from its 200-day moving average. Just as it will be way above it at the top of the market, it will be significantly below it come the bottom.

Bear markets on the charts

Bear market rallies exist to catch us out. After a huge sell-off, the market picks up strongly, convincing many investors that good times have replaced the bad times again. However, the dawn subsequently proves to be a false one. The rally reverses and the bear market resumes with a vengeance.

This pattern will be familiar to anyone who was involved in the market between 2000 and 2003. In that period, the FTSE 100 enjoyed several strong bounces that gave false hope to bulls and probably cost them a fair bit of money, too.

It is now obvious that the FTSE's progress between August and November was a bear market rally and therefore that the correction that began in July never really ended. Of course, hindsight is a wonderful thing. But at least one theory gave us strong hints that we should have distrusted the index's comeback right from the start.

The Elliott Wave Principle has much to say about the nature of market corrections. According to this branch of technical analysis, a 'flat' correction is one where the market sells off and then recovers close to its previous high - and perhaps even beyond its previous high - and then resumes its downtrend.

Flat corrections are primarily identified as such by their form. They are known as '3-3-5' corrections because of their structure. The first leg of the summer sell-off developed in three waves, rather than five. This was a vital clue that the correction might be of the flat variety, a suspicion that was confirmed once the August-November rebound also occurred in three waves.

As a result, Elliotticians would expect the correction to complete with a five-wave sell-off. The Wave Principle highlights some likely ending targets, using the Fibonacci relationships between the various waves. Having already exceeded its August low of 5822, we might typically expect a flat correction to terminate somewhere near 5246. A more severe sell-off might take us down to 4314.

Conventional technical analysis also suggests a correction ending below 5000. The dimensions of the 'double-top' pattern formed by the summer's price action gives a measured price objective of 4890.

Taking an even longer-term view, Elliott Wave Theory suggests an even more frightening scenario. What if the entire stock market recovery since 2003 was nothing more than a giant flat correction? As far as the Dow Jones index is concerned, this is the interpretation favoured by Robert Prechter, the world's leading authority on the Wave Principle.

If correct, this view would have terrifying implications for equity markets over the coming years. The final leg of this bear market would be a devastating five-wave decline that could easily take the FTSE 100 back to its 2003 lows of 3278. But it could be even worse. A more severe decline would potentially knock around 5943 points off the index, taking it to an all-time low of just 811.

Elliott Wave Theorists have developed a reputation over the years for making extreme predictions such as these. Bob Prechter, for example, correctly forecast the greatest bull market of all time during the dark days of the 1970s. Having achieved guru status through this forecast, he then turned into an ultra-bear in the 1980s, calling for a catastrophic collapse in equities. He has retained this stance ever since, so far without seeing his prophecies realised.