Extreme events rather than slowing growth or declining earnings are what cause bear markets. Under normal economic conditions, the equity markets always discount higher prices in advance, regardless of the prevailing level of interest rates or corporate earnings.
Equity markets do not like extreme events. Extreme events, such as a real estate crisis, a rapid rise in inflation, or a pandemic, frighten investors. The recent inflation spike was the cause of the 2022 bear market. Prior to that, the pandemic event was the primary cause of the 2020 bear market. Lehman Brothers’ collapse in September 2008 was the primary cause of the 2008 bear market. The dot-com bear market started with a large number of tech startups going out of business and accelerated after the 9/11 event.
All bear markets have something in common: they are unpredictable using fundamentals, or worse, technicals. Extreme events will always occur, making them almost predictable. Investors have various responses to extreme events and bear markets: some panic and sell, some see those as opportunities to add to long-term positions, and some just do not care because they know the central bank controls the quantity of money and will always act to ensure stable prices and long-term growth. Others use timing methods that provide improved risk-adjusted returns. Here is an example of a simple timing strategy.
Trying to forecast bear markets is a futile exercise. No one can predict extreme events or their effect on market prices. Every day, numerous articles in the financial mainstream and on social media attempt to predict the next bear market by predicting extreme events. These predictions are usually wrong, and even if they happen, the timing is uncertain.
After the recent inflation spike, the market experienced a significant decline, but it rebounded despite interest rates remaining high as investors began to discount higher future prices due to the central bank’s response function. Although the Fed has not reduced rates yet, investors are certain there will be a quick normalization soon. Another extreme event, such as the following, will trigger a bear market.
- A collapse of AI startups is similar to the collapse of tech companies during the dot-com crash.
- There could be a potential banking crisis and defaults, similar to what happened in 2008.
- There could be a new pandemic that will affect economic activity, just like it did in 2020.
- Another spike in inflation occurs due to unexpected developments, as happened in 2022.
- Some other extreme events occur, including the possibility of a war disrupting supply lines.
All of the above are low-probability events with unknown arrival times. The timing is not predictable. Stocks may continue to rise for the next two, three, five years, or even longer before an extreme event causes a bear market. The bottom of the next bear market could even form at price levels higher than current. All of these should serve as a reminder that attempting to forecast or predict these events is not only a futile exercise, but also a poor method of managing money. When these extreme events occur, risk management is critical, and some simple indicators could help more than most people believe.
Free Book
Get a free PDF of the book “Profitability and Systematic Trading” (Wiley, 2008) by subscribing to the Price Action Lab blog’s free email notifications of new posts and updates.
Premium Content
By subscribing, you have immediate access to hundreds of articles. Premium Articles subscribers have immediate access to more than two hundred articles, and All in One subscribers have access to all premium articles, books, premium insights, and market signal content.
Disclaimer: No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.
Charting and backtesting program: Amibroker. Data provider: Norgate Data
If you found this article interesting, you may follow this blog via RSS, email, or Twitter.
