Introduction

Until now, we have only discussed about setups and concepts from a bullish view. The reason for this has majorly been that Indian markets are inherently bullish. The Indian equity markets have not experienced a recession in technical terms. Although, the markets have experienced a systematic bearish trend. By systematic bearish trend I mean unwinding of bullish positions held for a long time by the bulls. The last time Indian markets experienced bearish markets was in 2008-09, 2011-12, 2015-16 and most recently in 2021-22. Each time the Indian markets entered a bearish trend, it has taken on an average 18 months to breach the previous high

Today’s newsletter is an interesting one. Today, we look at other side of the spectrum. Today we deep dive into bear markets, how to recognize if we are in a bear market, what causes bear markets and what to do in a bear market. This newsletter is going to be longer than the usual newsletters.

What are Bear market?

The definition of bear market is when the market falls 20% or more from it’s All Time High. This decline is not sharp. Rather, it is for a prolonged period of time. Let us understand this from a classical theory point of view. I have referenced to Dow theory many times so let’s use it this time as well. According to the Dow Theory, prices move in Primary trend and Secondary trend. Primary trend is a long-term trend in the market and the Secondary trend is correction to the primary trend. Correction means to move in the opposite direction of the primary trend. These two set of trends happen on every timeframe, from a few minutes to a few days or a few weeks. The thing is every once in a while, the correction happens on monthly timeframe as well.

Look at the chart above of Nifty 50. The primary trend is bullish and every once in a while, the price entered correction. The corrections marked in the red box are the ones mentioned above. Bear market is simply a secondary trend of a bigger bullish primary trend. This secondary trend can go on for months before resuming the primary trend.

How to recognize a bear market?

There are two primary ways to recognize if the equities markets have entered a bear market: Recession and Falling stock market index. These two are inter-related.

Recession is a widespread economic downturn. In a recession, consumer demand is low and this can cause a self-perpetuating cycle. When the consumer demand is low, the companies cut back on production, cutting back production leads to low economic output and therefore layoffs. Layoffs result in the laid off employees cutting back on the spending, which in turn affects the consumer spending. High unemployment could be a leading indicator to recognize a recession as well.

When recession takes places, the profits of companies across the market declines. This decline in profits if reflected in the price decline as well. A stock market index such as Nifty or Sensex is a portfolio of companies that represent the whole equity market. When the price declines, so does the index value.

So, when the Stock market index starts to decline or there is a widespread economic downturn, the probability of the markets entering a bear market is high.

Causes of a bear market

It must be clear by now economic downturn is the reason for a bear market. But what causes this economic downturn? Some of the major reasons for economic downturns are socio-economic turmoil, War, and world-wide recession.

A country is made up of its people. These people work every day to help the economy work like a well-oiled machine. If a country faces social unrests within the country in the form of protests, changing demography, poor policy making, or even poor governance, it affects the economy which in turn affects the operations of the economy. Social unrest not only impacts not only physical capital but also the intellectual capital. Social unrest can have psychological impacts too.

Wars are another reason for economic downturn. Two of the major depressions or recession the world has witnessed were because of wars. When wars take place, the country’s resources are focused on defending the nation rather than improving the economy. Wars result in destruction as well. This means the progress up until now is destroyed as well. It has rarely been seen that a civilization that has been a prolonged war has been able to survive economically.

Globalization has connected economies around the globe. Many economies which were once closed have greatly benefitted from globalization. It has helped in economic expansion, improved knowledge of business, new opportunities etc. But this has not come free. Globalization also has spillover effect. When one country faces recession or economic downturn, it experiences reduced consumer spending. This reduced consumer spending can affect the imports from other economies and can have a spillover effect. Therefore, causing economic downturn in other economies as well.

These are only some of the reasons for economic downturns and therefore bear markets. The world is full of uncertainties, and anything can cause an economic downturn. The point here is that these factors directly or indirectly affect the equity markets and therefore the trader’s positions. These factors can result in prices to decline for a prolonged period of time until the economy starts to recover.

Types of bear market

Bear markets can be broadly classified into two categories based on their duration: Secular and Cyclical.

Secular bull and bear markets form as a result of broad economic expansion in the economy due to technological advances. This expansion mainly results in corporate profits. The start of the secular bull market is a result of new technology and improved efficiency. The bull market includes new goods and services and new types of jobs. It can be thought of as a great reset. The secular bull markets last for somewhere around 15 to 20 years. Sometimes even more. But when the correction comes, the secular bear market last for years as well; somewhere around 5 to 6 years. One of the examples is the Industrial revolution. Another example could be the IT boom in the early 1990’s

The Japanese economy experienced a prolonged period of stagnation and deflation, often referred to as a "secular bear market," especially during the 1990s and 2000s. This period, known as the "Lost Decade," actually extended into two decades for many aspects of the economy.

Cyclical bull and bear markets however are shorter than secular ones. These also lack the depth of the secular markets. Cyclical bear and bull markets are as a result of business cycle. The cyclical bull markets usually last for a few years and then cyclical bear markets lasts for a year or two. One of the features of cyclical markets is that the business cycle affects one economic segment, but the effect can be seen in other segments as a result of the sell off triggered.

A secular market is made up of many cyclical markets. Indian Markets have gone through the phase of multiple Cyclical bear markets in the past.

Identifying Bear Markets using Charts

It’s evident that a bear market often follows when the disparity index of the 50 EMA exceeds 40. But why does this signal the beginning of a downturn? The key lies in the broader economic implications. When the disparity index spikes, it reflects overextended market conditions. Such imbalances typically precede a period of correction or decline.

Historical data shows that these red-flag moments, marked by the red spots on the chart, coincided with major global events like the 2008 financial crisis, the devaluation of the Chinese Yuan in 2015, and the COVID-19 outbreak in 2020. These events triggered economic downturns, leading to significant market sell-offs. When the disparity index hits these critical levels, it suggests that the market may be overbought, and a correction could be imminent, often marking the start of a bear market.

Just like socio-economic turmoil, wars, or global recessions can lead to economic downturns, these technical indicators can help traders anticipate when a bear market is likely to begin, signaling a time for caution in trading positions.

Identifying Opportunities in Bear Markets

Bear markets and broader market corrections might seem daunting, but they often pave the way for new market leaders to emerge. History teaches us that after every downturn, certain sectors outperform others, offering valuable opportunities. For instance, during the 2008 crisis, the Banking and IT sectors outshone the rest. In 2010-11, it was FMCG, Pharma, Auto, and IT that took the lead, while Consumption and Energy sectors were the top performers in 2015-16. More recently, in 2020, Pharma, FMCG, and IT sectors thrived, and in 2021-22, Auto and Energy sectors emerged as leaders.

Therefore, instead of fearing market corrections, we should closely monitor which sectors are relatively outperforming the broader markets.

This approach allows us to identify promising trading and investing opportunities that could lead to substantial gains as the market recovers.