A Bear Market Has 2 Phases

|
Includes: SPY, XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, XLY
by: Eric Parnell, CFA

Summary

The specter has been rising that stocks may eventually break to the downside and threaten to enter into a new bear market.

Stocks do not universally fall to the downside all at once, as the onset of a bear market tends to be more nuanced.

Bear markets have two phases, which is a critical point for investors in positioning for whatever market environment may lie ahead.

The U.S. stock market has struggled to break out to new highs since late last year. And with the bull market already long by historical standards at a time when corporate earnings have stalled and monetary policy may soon be tightening, the specter has been rising that stocks may eventually break to the downside and threaten to enter into a new bear market. But if such an outcome were to come to pass, it is important to recognize that the market does not just simply fall to the downside all at once. Bear markets tend to be more nuanced. This includes the fact that they almost always have two phases. And this point is critical for investors seeking to position for any such future outcome.

The Two Phases Of A Bear Market - First Phase

Many investors have the notion that everything falls sharply to the downside all at once when stocks enter into a bear market. But history has shown that this is not the case. Instead, the onset of a bear market is often much more gradual. And this is true even if the initial catalyst that sparks the bear market is violent. This is due to the fact that investor psychology is something that tends to change only gradually over time, which is the key reason why so many investors only realize that they are trapped in a bear market when it is far too late to do anything about it. Such is the reason why bear markets typically have two phases.

The First Phase - 2000 to 2003 Bear Market

The first phase of a bear market is marked by a wide dispersion within the stock market itself. When a bear market first gets underway, it is frequently driven by a sector or industry that had previously been a key market leader. As a result, when the first major declines strike the market, the losses are often concentrated in this leading segment and investors view the initial pullbacks as long awaited buying opportunities that have finally arrived. As for the other segments of the market that were either moving steadily along or may have even been neglected, they often either continue in their previous trend or may even benefit, as capital rotates out of the leading sector or industry and into these more neutral to overlooked categories. As a result, many stock segments can continue to perform well for some time, even though a bear market is already underway.

Let's reflect on the previous two major bear markets to illustrate how the first phase of a bear market typically plays out.

Back in the late 1990s, the technology sector was the extraordinary high flyer that propelled the broader market to dizzying heights. So when the bear market got underway in early 2000, it was the technology sector that was caught in the crosshairs of the decline. But what about the rest of the stock market during this time? What is often forgotten about the bear market at the turn of the millennium is how concentrated the losses were in the technology sector for much of the experience.

For the sake of illustration, let us first reflect on the nearly two-year period from March 24, 2000 when the S&P 500 Index (NYSEARCA:SPY) reached its bull market peak at the time through March 19, 2002.

With the bursting of the technology bubble, the once high-flying technology sector (NYSEARCA:XLK) was devastated during this time in losing -65% of its value. This helped drag the broader market, as measured by the S&P 500 Index, lower by -22% over this same time period.

But many segments of the market were actually performing well over this same time period. We'll begin with the outright winners. Consider the performance of the consumer staples (NYSEARCA:XLP), financials (NYSEARCA:XLF), and utilities (NYSEARCA:XLU) sectors during this same time period. These three segments gained by +27%, +12% and +8% at a time when the technology sector in particular, and the broader market in general, were getting smashed. And these sectors were almost universally in positive territory for the first two years after the start of the bear market in March 2000.

How about the rest of the market? While they were not necessarily surging in the same manner as the three sectors above, most still performed well during this first phase in their own right. Although they endured declines in value to varying degrees along the way during the first phase of the bear market, they were still flat to positive over the entire bear market from March 2000 through March 2002. This included consumer discretionary (NYSEARCA:XLY), materials (NYSEARCA:XLB) and energy (NYSEARCA:XLE) stocks that were all up in the mid single-digit range, and health care (NYSEARCA:XLV) and industrials (NYSEARCA:XLI) that were only down in the low single-digits.

All of this leads to an important conclusion. While the U.S. stock market, as measured by the S&P 500 Index, was down -22% during the first phase of the 2000 to 2003 bear market that lasted roughly two years, eight of the nine sectors that make up the S&P 500 Index were outperforming this broader market measure by twenty percentage points or more, including six that were positive over this time period. The only sector that was dragging the market lower was technology.

The First Phase - 2007 to 2009 Bear Market

Let's now fast forward to the bear market from 2007 to 2009. We will focus on the period from the first bull market peak on July 19, 2007 through the Friday before the collapse of Lehman Brothers on September 12, 2008. This is a period lasting more than a year at fourteen months.

With the onset of the financial crisis, the financial sector was routed during this first phase of the bear market in losing more than -50% of its value along the way. Given that financials were the largest sector in the S&P 500 heading into the financial crisis, this helped drag the broader market lower by nearly -17% over this time period.

But while financials were badly bleeding, some other sectors were performing quite well. Leading among these was the consumer staples sector, which was higher by more than +8% during this first phase of the bear market and was almost universally in positive territory along the way. Others that performed well during this first phase were energy, materials and utilities stocks, which were meaningfully higher in the summer of 2008 just a couple months before the Lehman failure that came in September.

As for the remaining four sectors, they all moved generally in line with the broader market, although it should be noted that health care was only lower by the mid single-digits as well by the time the Lehman bankruptcy came.

But once again, we have a broader market where a bear market is well underway, yet many market sectors are still performing well.

The Two Phases Of A Bear Market - Second Phase

So why do investors harbor so much fear about the threat of a bear market? Because it is in the second and final phase where things get nasty.

The Second Phase - 2000 to 2003 Bear Market

Let's return to the 2000 to 2003 bear market. It was technology stocks that led the decline in the first phase, and the pain does not let up in the second phase from March 19, 2002 to March 11, 2003.

But what is notable is that the previous winners in the consumer staples, financials and utilities sectors surrendered their leadership and started also moving in lockstep sharply to the downside.

And as for those other segments of the market that were holding their own during the first phase of the 2000 to 2003 bear market, they also gave up to the downside.

In short, in the second phase of a bear market, virtually everything moves to the downside. And it does so in a meaningful way.

The Second Phase - 2007 to 2009 Bear Market

Let's return to the 2007 to 2009 bear market. In the second phase from the collapse of Lehman through to the bottom on March 9, 2009, the financial sector continued to the downside and is completely demolished in the process, dropping another -70%.

The former winners are also taken down, as consumer staples, energy, materials and utilities all fell in line with the broader market in moving sharply to the downside.

As for the remaining sectors, they also all joined in a similar pattern with the broader market to the downside.

Put simply, a bear market eventually arrives at a point where the previous dispersion no longer takes place. At this stage, the negative forces of the broader market have accumulated to the point that it is inducing capitulation even among the winners through mass selling and broad liquidations. In short, very few stocks survive the second phase of a bear market with their gains intact, as virtually everything is taken place by the mauling of the bear.

Perspectives For Today

Perhaps we are witnessing stocks putting in a bull market top this summer. Then again, maybe this has just been an extended period of consolidation ahead of stocks gearing up for another surge higher in the final months of the year. Only time will tell.

But for those investors concerned we may be on the brink of a new bear market phase, it is important to remember that bear markets do not typically take out all stocks at once. For while the numerous sectors that have been propelled higher by momentum and sport lofty valuations may suffer undue damage during the first phase of the next bear market, a number of other selected sectors whose performance has been more middling and less exciting stand the potential to perform rather well amid such a shift. The key is identifying those sectors that offer attractive relative and absolute value in the current environment, while also providing the potential for more predictable revenue and earnings streams even if the operating environment becomes more turbulent going forward. A number of stocks from the utilities and consumer staples set up particularly well in this regard today.

Of course, the time eventually comes in any future bear market where the second phase begins and all sectors begin moving in unison to the downside. Thus, investors will do well to avoid complacency even if they are positioned for the first phase of the next bear market. For those investors that are actively watching for any such transitions in bear market phases stand a much better chance of avoiding the real damage when the time finally comes.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Expand
Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500.
Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here