If you watch the financial news or read about the capital markets you will hear the terms “bull market” and “bear market” nearly every day. These terms are used to describe market conditions. Since the direction of the market is a force that impacts the value of your portfolio it is important to understand these terms and how they can alter the value of your assets.
What Are Bear Markets and Bull Markets?
The terms bear and bull markets are used to characterize the general direction of markets. A bear market refers to a market that is declining in value. A bull market describes a market that is appreciating. In addition to describing the direction, the terms bull market and bear market refer to investor sentiment and future trends. In essence, a bear market refers to a market that has declined 20% from its most recent peak in value. Share prices are dropping and trending lower as investor sentiment sours. As investors sell their positions, their confidence in riskier assets lessens, and their willingness to spend discretionary income fades. During a bear market, economic growth initially slows and then contracts as raising money in the capital markets become more difficult. Eventually, unemployment beings to climb and consumer spending drops. In contrast, a bull market describes a market that is on the rise. The trend in the price of assets is climbing and investor sentiment rises. During bull markets, economic growth is expanding and consumer spending increases. Employment levels are increasing and consumers are happy to spend their discretionary income. A bull market can be defined as a 20% rise from the most recent trough in prices. During a bull market, investors often have faith that the uptrend in prices will continue for an extended period.
Supply and Demand for Assets
During bull markets, there is a strong demand for securities which helps push prices higher. The upward trend in the direction increases the likelihood that new companies will come to the capital markets to raise cash. During this period, the demand from the investor base can easily soak up additional supply from a new company. As a result, when a company looks to the capital markets to launch an initial public offering (IPO) they will generally favor a period during a bull market. In a bear market, investors are looking to sell generating excess supply. The demand is significantly lower than supply which drives prices lower. Companies that are looking to raise funds in the capital markets will shy away during bear markets. Bull and bear markets apply to all markets but are generally a characterization of stock markets. While this applies to all-markets, some markets, like the currency markets, are not straightforward. A bull market for a currency pair means one currency is going up while another is declining in value. A bull market for the USD/JPY means the dollar is rising, and a bull market for the EUR/USD means the dollar is falling in value. Since the concept of a bull market for the dollar can mean different directions for currency pairs, there is a need to focus on each pair when describing a bull and bear market.
What are the Characteristics of Bear and Bull Markets
While the underlying direction of the price of the market is one of the main characteristics that defines bull and bear markets, several attributes underlie bear and bull markets.
- Positive sentiment
- Expanding economic growth
- Falling unemployment
- Rising IPO’s
- Falling interest rates
- Negative sentiment
- Contracting economic growth
- Rising unemployment
- Falling IPO’s
- Increasing interest rates
What Happens to Interest Rates during Bear and Bull Markets
Interest rates are a key factor during bull and bear markets. Historically, as prices rise, and sentiment increases during a bull market, a central bank will begin to increase interest rates to reduce the chance of runaway inflation. Recall, inflation is the value of a basket of goods and services. If prices of everyday goods and services rise because sentiment surges out of control, the general population will soon not be able to afford items needed for survival. In essence, bull markets have historically come to an end because interest rates rise to the point where they reduce inflation and choke off economic growth. During a bear market, a central bank is generally in the process of reducing interest rates to spur on growth. During a bear market prices are falling, and declining interest rates are geared to increase inflation and increase economic growth. As interest rates fall, they increase the value of future discounted cash flows thus helping stock prices to gain traction.
The market environment has a direct effect on how consumers behave. When stock prices rise, investors feel like they have more money, even if the gains are unrealized. Rising consumer confidence is generally highly correlated to stock prices, and therefore this directly impacts consumer spending. During bull markets, as prices are rising and unemployment is falling investor, psychology improves. During a bear market, market sentiment is falling as investors take money out of riskier assets and move then into safe-haven assets such as cash, fixed income, and gold. Investors’ psychology sours as prices fall which directly impacts spending.
Stock prices and economic output are directly related. The value of thousands of business is directly related to the price of their stock. When the value of a company changes it will directly impact their ability to spend money to run operations. As the value climbs, it will become easier to borrow more capital and expand a business. When the value of a company declines, management will be more interested in reducing expenses. Since companies are participants in economic growth, the value of stock prices can directly impact economic growth and employment.
The Bottom Line The terms bear market and bull market describe the direction of a market as well as the characteristics associated with an increase or decrease in market values. Bull markets are associated with rising prices and positive sentiment, whereas bear markets describe falling prices and negative sentiment. Additionally, bull markets are generally associated with economic expansion and falling unemployment. Bear markets occur when economies are contracting and unemployment is rising.