Market bubbles are well-known, and many of us know someone who has been trapped in one. Despite the fact that there are several lessons to be learnt from previous bubbles, market players are nonetheless lured in whenever a new one emerges. A bubble is merely one of numerous market stages, and it is critical to understand these phases in order to avoid being caught off guard.
Knowledge how markets function and a solid understanding of technical analysis may help you identify market cycles.
- Understanding how each phase works and how to profit from it is the difference between floundering and prospering in the market.
- The market has bottomed during the accumulation period, and early adopters and contrarians perceive a chance to step in and grab up bargains.
- The market seems to have leveled out during the mark-up period, and the early majority is rushing back in, while the wise money is cashing out.
- During the distribution phase, mood shifts from neutral to somewhat pessimistic, prices are turbulent, sellers rule, and the rally’s conclusion is imminent.
- Laggards attempt to sell and salvage what they can during the mark-down period, while early adopters search for indications of a bottom so they can get back in.
The 4 Phases of a Market Cycle
Cycles are present in all parts of life; they span from the extremely short-term, such as the life cycle of a June bug, which lives just a few days, to the billions of years of a planet’s life cycle.
Whatever market you are referring to, it all goes through the same stages and is cyclical. They climb, peak, drop, and ultimately fall. When one market cycle concludes, the next starts.
The issue is that most investors and traders either fail to comprehend that markets are cyclical or fail to anticipate when the present market phase will terminate. Another big issue is that, even if you accept the existence of cycles, predicting the top or bottom of one is practically impossible. However, knowing cycles is critical if you want to optimize your investment or trading profits. Here are the four key components of a market cycle, as well as how to identify them.
1. Accumulation Phase
After the market has bottomed, innovators (business insiders and a few value investors) and early adopters (clever money managers and experienced traders) begin to purchase, believing the worst is past. At this point, values are highly appealing, yet market sentiment is still gloomy.
Media articles predict doom and gloom, and some who were long through the worst of the bear market have lately given up and sold the remainder of their holdings in disgust.
However, prices have flattened throughout the accumulation period, and for every seller who throws in the towel, someone is there to take it up at a nice bargain. The overall market attitude shifts from negative to neutral.
2. Mark-Up Phase
At this point, the market has remained steady for some time and is starting to rise. The early majority has jumped on board. This category comprises technicians who realize market direction and emotion have changed when the market makes higher lows and higher highs.
Although media sources begin to speculate that the worst is gone, unemployment continues to climb, as do rumors of layoffs in a variety of industries. As this stage progresses, more investors join the bandwagon as fear of being out of the market is replaced with greed and fear of being left out.
As this phase comes to a close, the late majority enters and market volumes begin to rise significantly. At this time, the greater fool idea reigns supreme. Values go well beyond historical standards, and logic and reason give way to greed. While the late majority enters, the smart money and insiders unload.
However, when prices begin to level off or the climb slows, laggards who have been waiting on the sidelines perceive this as a buying opportunity and rush in. Prices make one more parabolic advance, referred to in technical analysis as a selling climax, during which the highest gains in the shortest intervals are often achieved. However, the cycle is reaching its end. During this phase, sentiment shifts from neutral to positive to outright exuberant.
3. Distribution Phase
Sellers begin to dominate the market in the third stage of the market cycle. This phase of the cycle is distinguished by a period during which the preceding phase’s bullish attitude transforms into a mixed feeling. Prices are often trapped in a trading range that may linger for many weeks or even months.
For example, when the Dow Jones Industrial Average (DJIA) peaked in February 2020, it traded down to around its previous top and remained there for many months.
But the distribution phase can come and go quickly. For the Nasdaq Composite, the distribution phase was less than a month long, as it peaked in Feb. 2020 andmoved higher shortly thereafter.
When this phase is over, the market reverses direction. Classic patterns like double and triple tops, as well as head and shoulders patterns, are examples of movements that occur during the distribution phase.
The current bull market is over 12 years old and is the longest-lasting bull run in history, with the S&P 500 higher by over 500% since hitting multi-year lows in March of 2009. The recent COVID-19 pandemic led to a slight pullback, but the market has quickly rebounded and continues to make new highs as of August 2020.
The distribution phase is a very emotional time for the markets, as investors are gripped by periods of complete fear interspersed with hope and even greed as the market may at times appear to be taking off again. Valuations are extreme in many issues and value investors have long been sitting on the sidelines. Usually, sentiment slowly but surely begins to change, but this transition can happen quickly if accelerated by a strongly negative geopolitical event or extremely bad economic news.
Those who are unable to sell for a profit settle for a breakeven price or a small loss.
4. Mark-Down Phase
The fourth and final phase in the cycle is the most painful for those who still hold positions. Many hang on because their investment has fallen below what they paid for it, behaving like the pirate who falls overboard clutching a bar of gold, refusing to let go in the vain hope of being rescued. It is only when the market has plunged 50% or more than the laggards, many of whom bought during the distribution or early markdown phase, give up or capitulate.
Unfortunately, this is a buy signal for early innovators and a sign that a bottom is imminent. But alas, it is new investors who will buy the depreciated investment during the next accumulation phase and enjoy the next mark-up.
Market Cycle Timing
A cycle can last anywhere from a few weeks to a number of years, depending on the market in question and the time horizon at which you look. A day trader using five-minute bars may see four or more complete cycles per day while, for a real estate investor, a cycle may last 18 to 20 years.
Image by Sabrina Jiang © Investopedia2021
The Presidential Cycle
One of the best examples of the market cycle phenomenon is the effect of the four-year presidential cycle on the stock market, real estate, bonds, and commodities. The theory about this cycle states that economic sacrifices are generally made during the first two years of a president’s mandate. As the election draws nearer, administrations have a habit of doing everything they can to stimulate the economy so voters go to the polls with jobs and a feeling of economic well-being.
Interest rates are generally lower in the year of an election, so experienced mortgage brokers and real estate agents often advise clients to schedule mortgages to come due just before an election.
The stock market has also benefited from increased spending and decreased interest rates leading up to an election, as was certainly the case in the 1996 and 2000 elections. Most presidents know if voters are not happy about the economy when they go to the polls, chances for re-election are slim to none, as George Bush Sr. learned the hard way in 1992.
The Bottom Line
Although not always obvious, cycles exist in all markets. For smart money, the accumulation phase is the time to buy because values have stopped falling and everyone else is still bearish. These types of investors are also called contrarians since they are going against the common market sentiment at the time. These same folks sell as markets enter the final stage of mark-up, which is known as the parabolic or buying climax. This is when values are climbing fastest and the sentiment is the most bullish, which means the market is getting ready to reverse.
Smart investors who understand the various stages of a market cycle are better prepared to benefit from them. They are also less likely to be duped into making a purchase at the worst possible moment.
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