By Scott Galbraith
Bull and bear markets reflect the fear and greed associated with risking capital. Historically, when prices rise, investors are content and fuel the fire of a bull market. When prices are falling, fear perpetuates, forcing traders to the sidelines. Several factors create bull and bear markets. Fundamental aspects such as interest rates, capital flows, and the value of a currency can drive the prices of riskier assets. Technical analysis can also be a self-fulfilling factor that can help generate a bullish or bearish change in the price of an investment. While both a bull and bear market are used to describe how markets perform, they are entirely different animals regarding the impact they can have on your portfolio and the investment decisions you make.
What are Bull and Bear Markets
The terms bull and bear markets generally refer to market conditions. While the concepts are usually geared toward stock prices, bull and bear markets can also describe other assets, such as bonds, commodities, CFDs, and forex. The term bull market refers to appreciating prices or exchange rates, and the term bear market refers to depreciating prices. Bull markets generally reflect complacency as prices move higher in a smooth trend. Bear markets are usually choppy and volatile. Since it is hard to time a bottom in the market, equity investors will often withdraw their capital exposed to the stock market and sit on cash until the coast is clear.
Investor Positions
Investors can speculate on rising prices, falling prices, prices moving sideways, and sitting out. While bull markets take time to develop, bear markets are usually quick to derive fear. Bull markets generate greed as they rise, and irrational exuberance infiltrates. Bear markets drive fear. Many investors participate in bull markets in one form or another. If you own a retirement fund or a college savings account, you are likely to have investments in the equity markets. When fear strikes, bullish investors can quickly turn bearish and remove their exposure to stocks.
What Drives a Bull and Bear Market?
Several factors create bull and bear markets. The most common in equity markets is the change in expectations of future interest rates. At their core, stocks are valued by looking at discounted cash flows of a company’s future earnings.
A change in interest rates will impact these future cash flows. For example, if a company is expected to make $100 in one year, and the current interest rate to value the company is 3% and rises to 4%, the value of the $100 changes from $97 today to $96 today. The change in the cash flow, therefore, reduces the cash flow value as interest rates rise. If the cash flow declines, the company’s value declines. Alternatively, if interest rates fall, the discounted value of the cash flow will increase, and the company will experience an increase in its price.
Discounted cash flows are not the only reason stocks will rise when interest rates decline. Lower interest rates reduce the cost of borrowing across the economy. Banks and other lenders become less restrictive when rates are declining. Corporate borrowing also becomes less restrictive when rates fall, which can help buoy corporate profitability. Unfortunately, if rates are low for too long, they will increase inflation expectations and reduce the buying power of consumers. When inflation starts to rear its ugly head, consumers will pull back on their purchases, reducing economic growth.
Inflation can also erode the value of a consumer’s purchasing power, especially if the consumer is on a fixed budget. For example, let’s assume you earn $3,000 per month and drive to work every day, spending $200 per week. If the price of gasoline increases by 20%, your costs of going to work have increased by $40 per week, but your income has remained unchanged. Your only recourse would be to reduce your spending on other goods and services.
When inflation rises too quickly, a central bank will pivot to turn off the spigots and start to raise interest rates. Part of higher prices is higher stock prices; therefore, when easy money becomes less accessible, the price of a stock will generally fall.
Other Factors that Drive Stocks
Capital flows and currencies are other factors that usually alter the trajectory of bull and bear markets. Capital flows describe the movement of money that could be invested and traded or business operations. So, if a company in a country needed to build a mine or factory, they would need investment capital. Capital flow could also pertain to research and development or purchasing another company. Capital flows are usually strong when a stock market is strong and economic growth is rising. Capital flows usually decline when a central bank tries to reduce economic growth and interest rates rise.
Additionally, a country’s currency can alter a bull and bear market. When a currency strengthens, an exporting country becomes less competitive as its goods and services price rise for buyers that use alternative currencies. For companies with a strong presence outside of their home currency, a stronger currency can mean less profitability outside their country.
Other Guides to Bull and Bear Markets
Another guide to whether you are in a bull or bear market is technical analysis. Technical analysis is the study of past price movements to determine the future directions of an asset. You can view different forms of technical analysis on a forex trading app. There are many aspects of technical analysis. Using moving averages is helpful when determining if you are in a bull or bear market. A moving average is the average of a specific number of days. When you move forward, a new day is added to the average and the first day used to calculate is dropped. For example, if you are calculating a 10-day moving average, on day 11, day one is dropped from the calculation.
An excellent way to use moving averages to determine if you are in a bull market or bear market is to use a moving average crossover strategy. A crossover strategy relies on two moving averages. For example, when a 50-day moving average exceeds the 200-day moving average, a long-term uptrend is considered in place. This moving average is also known as the “golden cross”. When this occurs, a bull market usually occurs. When the 50-day moving average exceeds the 200-day moving average (known as the death cross), a bear market is generally considered in place.
Using Technical and Fundamental Analysis Together
Fundamental analysis studies macro events and generally focuses on interest rates and capital flows. When a central bank decreases interest rates and you see that a golden cross has occurred, you might feel confident that a bull market is emerging. Conversely, if a central bank is tightening interest rates and making borrowing more costly and a death cross occurs on a broad equity index, you might feel confident that a bear market is in place.
The Bottom Line
There are several ways to help you decide if a bull market or a bear market is occurring. Bull and bear markets reflect fear and greed. Bull markets are more natural in the equity markets as investors expose their capital to generate long-term gains for their retirement or university savings.
Generally, when prices rise, investors are content. When prices are falling, fear perpetuates, forcing traders to the sidelines. Volatility usually increases as investors look to protect their gains.
Several factors create bull and bear markets. Fundamentals such as interest rates, capital flows, and the value of a currency can drive the prices of riskier assets. As interest rates fall, borrowing costs decline, and the discounted value of future cash flows increase. As interest rates rise, borrowing becomes more expensive, and discounted cash flows decline.
Technical analysis is another factor that can help in guiding whether there is a bullish or bearish change in the price of an investment.
You can also use technical and fundamental analysis to help guide you to whether you are in a bull or bear market. If you see a bullish technical trend and a central bank is simultaneously decreasing interest rates, you might feel confident that you are in a bull market. Conversely, if you see a bear technical trend and a central bank is increasing interest rates, you might feel confident that you are in a bear market. Understanding the type of market environment, you are in will help you determine the trading strategy you want to employ to generate profits.