A severe bear market is something to fear

Philip Coggan wonders whether current stock market crashes will plunge to past depths of financial dislocation - FT 98-09-03

A full bear market in all its horror is something that investors in the US and Europe have not seen for a generation. The crash of 1987 offered a glimpse but the fall in share prices was short-lived and the effect on the real economy was relatively limited.

The standard definition of a bear market is a fall of 20 per cent in prices, which means that several European markets - Frankfurt, Madrid and Zurich - have already qualified since their July peak. It has not yet happened in the US, but only if you measure the stock market by the Dow Jones Industrial Average of 30 leading shares. The Russell 2000 index of smaller stocks has declined 29 per cent from its high in April.

The latest work on the subject (The Bear Book Survive and Profit in Ferocious Markets by John Rothchild, published by John Wiley & Sons, New York) estimates that, by this definition, the US has experienced around 25 bear markets this century, or around one every four years.

But many of these declines would not fall into the severe bear market category. In a severe bear phase, the share price decline is so sharp that recovery takes years, not months and the financial dislocation has substantial effects on the real economy.

For an example of a severe bear, one need look no further than Japan, where the Nikkei 225 average stands at less than half its 1989 peak level and the banking sector is still suffering from the impact of the market's fall.

Probably the two classic bear markets of the century occured between 1929-1932 and 1973-1974. The sheer duration and scale of those declines ruined many investors. The US market's low did not occur until three years after "Black Thursday" in October 1929 and the Dow Jones Industrial Average did not reclaim its peak level until 1954.

Those who believe, as now, that it makes sense to "buy on the dips" were bitterly disappointed. The 34.9 per cent fall in the UK market in 1973 did not represent a buying opportunity, since shares fell a further 54.7 per cent in 1974.

Such severe drops have a particularly adverse effect on those who have borrowed money to invest in the market.

In 1929, many investors were operating on margin accounts, through which they only had to put up 10 per cent of the cost of the holdings. When share prices fell more than 10 per cent, they not only lost all their capital, they had to find more money to cover the deficit. Hedge funds are the obvious modern equivalent of such leveraged investors.

The 1973-74 bear market was so severe because it was not confined to share prices. As the oil price rose and inflation soared, property and bonds suffered almost as heavily as equities. Cash is king was the motto of the era.

Prices suffer severely in such markets because investors are forced into selling at a time when it is very hard to convince anyone else to buy. The stock market starts to resemble a "closing down sale" at a defunct high street store, with shares selling at knockdown prices.

Few are predicting such conditions will occur in the US or Europe this time. But investors in Russia, where the RTS index has dropped 83 per cent this year and 66 per cent since July 20, now know all about bear markets.

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