Three Varieties of Bear Markets

Many different causes can trigger a bear market, but usually the cause has something to do with the economy. Here are three common causes of bear markets, as well as what types of investments tend to do best in each type of bear market.

Recession

A recession hit the U.S. in late 2007, according to the National Bureau of Economic Research. That's when the spillover effects from the moribund housing market and financial-services woes began to affect consumer spending. What's more, business spending and hiring slowed to a halt as companies pared back their budgets in an effort to slow the deterioration of their profit margins. While inflation remained in check, the economy shrank all the same.

Firms that deliver inexpensive or staple products, such as food, beverages, cigarettes, and health-care items, tend to do well in a recessionary environment. Other stocks, such as automakers, steel producers, and paper manufacturers—as well as retailers of discretionary goods like clothes and housewares—are highly sensitive to economic cycles. Hence they are termed cyclicals. High-yield bond funds (junk bond funds) can also be risky when the economy sours, because some companies may have trouble paying back their debtholders.

Rapid inflation

From the 1960s through the 1980s, many investors viewed inflation as a given. Not even common stocks could protect investors from the price increases of the late 1970s. During normal circumstances, stocks have provided an annual return that has outpaced inflation over the long term, but during the inflationary 1970s, even those stocks struggled. Bonds may also lose value during inflationary environments as higher prices erode the buying power of their payouts.

As a result, investors in the 1970s flocked to tangible assets such as real estate, art, and gold. Today, investors have even more direct ways to hedge their portfolios against the threat of rising prices, including inflation-indexed bonds and commodities investments, which enable investors to benefit when the prices of hard assets like oil and gas, timber, and metals are on the rise.

Everything else, including regular bonds and stocks not tied to some hard asset such as real estate, tends to lag during periods of rapid inflation.

Deflation

During and after the recession and financial crisis from late 2007 through early 2009, deflation became the economic worry du jour in the United States. Pundits speculated that with anemic consumer spending amid a shaky economy, the prices of goods would drop, sparking a general fall in the U.S. Consumer Price Index—or in other words, deflation. For a variety of reasons, deflation makes it more difficult for businesses to grow their profits, thus weakening stock prices.

Long-term and intermediate-term bond funds tend to hold up relatively well in this environment, because their dividends are effectively worth more in this type of economy. A 6% dividend delivers more purchasing power each year if prices are falling by 2% annually. In addition, interest rates often decline during deflationary environments, making already-issued bonds with higher interest rates even more valuable. Among equities, look for dividend-rich stocks and the funds that own them.

What suffers? Inflation-indexed bonds, non-dividend-paying stocks, and anything tied to a real asset such as gold, real estate, or commodities do poorly in a deflationary environment. Remember, deflation means a decline in the prices of tangible assets.