We have all heard of market bubbles and many of us know someone who has been caught up in one. Although there are many lessons to be learned from past bubbles, market participants continue to be sucked into each time a new one appears. A bubble is just one of several phases of the market, and to avoid being caught off guard, it is essential to know what those phases are.
Understanding how markets work and a good understanding of technical analysis can help you recognize market cycles.
The number of phases in a market cycle; they are accumulation, markup, distribution, and discount.
The four phases of a market cycle
Cycles prevail in all aspects of life; They range from the very short term, such as the life cycle of a June insect, which lives only a few days, to the life cycle of a planet, which takes billions of years.
No matter which market you refer to, they all go through the same phases and are cyclical. They go up, peak, go down, and then bottom out. When one market cycle ends, the next begins.
The problem is that most investors and traders either fail to recognize that markets are cyclical or they forget to wait for the end of the current market phase. Another major challenge is that even when you accept the existence of cycles, it is almost impossible to choose the beginning or the end of one. But understanding cycles is essential if you want to maximize your investment or trade returns. Here are the four main components of a market cycle and how you can recognize them.
- Markets move in four phases; understanding how each phase works and how to benefit is the difference between faltering and flourishing.
- In the accumulation phase, the market has bottomed out, and early adopters and opponents see an opportunity to jump in and get discounts.
- In the markup phase, the market appears to have stabilized and the first majority is re-entering, while the smart money is being cashed out.
- In the distribution phase, sentiment turns mixed to slightly bearish, prices are choppy, sellers prevail and the end of the rally is near.
- In the downsizing phase, laggards try to sell and get back what they can, while early adopters look for underlying signals so they can get back in.
1. Accumulation phase
This phase occurs after the market has bottomed out and innovators (corporate savvy and some value investors) and early adopters (savvy money managers and seasoned traders) start buying, thinking the worst is over. At this stage, valuations are very attractive and overall market sentiment remains bearish.
Articles in the media preach pessimism and pessimism, and those who have long been through the worst of the bear market recently gave up and sold the rest of their properties in disgust.
However, in the accumulation phase, prices have stabilized and for every salesperson who throws in the towel, someone is there to pick it up at a good discount. The general market sentiment begins to change from negative to neutral.
2. Profit margin phase
At this stage, the market has been stable for a while and is starting to rise. The early majority are getting on the train. This group includes technicians who, seeing that the market is reaching higher lows and highs, recognize that the market direction and sentiment have changed.
Media stories begin to discuss the possibility that the worst is over, but unemployment continues to rise, as do reports of layoffs in many sectors. As this phase matures, more investors jump on the bandwagon, as the fear of being in the market is replaced by greed and the fear of being left out.
As this phase begins to come to an end, the late majority step in and market volumes begin to increase substantially. At this point, the big fool theory prevails. Valuations far exceed historical norms, and logic and reason take a backseat to greed. While the late majority are coming in, the smart money and the savvy are unloading.
But as prices start to stabilize, or as the rise slows, laggards who have been on the sidelines see this as a buying opportunity and jump in en masse. Prices make one last parabolic move, known in technical analysis as a selling climax when the biggest gains often occur in the shortest periods. But the cycle is nearing the top. Sentiment goes from neutral to bullish to downright euphoric during this phase.
3. Distribution phase
In the third phase of the market cycle, sellers begin to dominate. This part of the cycle is identified by a period in which the bullish sentiment from the previous phase turns into a mixed sentiment. Prices can often remain locked in a trading range that can last for a few weeks or even months.
For example, when the Dow Jones Industrial Average (DJIA) peaked in January 2000, it traded close to its previous high and stayed there for a period of more than 18 months. But the distribution phase can come and go quickly. For the Nasdaq Composite, the distribution phase lasted less than a month, as it peaked in March 2000 and receded shortly thereafter.
When this phase ends, the market changes 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 10 years old and the longest running bull run in history, with the S&P 500 higher by more than 300% since hitting multi-year lows in March 2009. After sliding in late 2018, It could be prepared for an eleventh year, depending on the outlook for the economy. But a recent series of large sell-offs and reverse trades has raised concerns that it could be losing steam.
The distribution phase is a very emotional time for the markets, as investors are trapped by periods of utter fear interspersed with hope and even greed, as sometimes the market can appear to be taking off again. Valuations are extreme in many respects, and equity investors have long been on the sidelines. Typically, sentiment begins to change slowly but surely, but this transition can occur quickly if accelerated by a strongly negative geopolitical event or extremely bad economic news.
Those who cannot sell for a profit settle for an equilibrium price or a small loss.
4. Sales phase
The fourth and final phase of the cycle is the most painful for those who still hold positions. Many hold because their investment has fallen below what they paid for, behaving like the pirate who falls overboard grabbing a bar of gold, refusing to let go in the vain hope of being rescued. It’s only when the market has slumped 50% or more that the laggards, many of whom bought during the distribution or markdown phase, give up or capitulate.
Unfortunately, this is a buy signal for early innovators and a sign that a bottom is imminent. But unfortunately, it is the new investors who will buy the depreciated investment during the next accumulation phase and enjoy the next margin.
Market cycle time
A cycle can last from a few weeks to several years, depending on the market in question and the time horizon you are looking at. A daily trader using five-minute bars can see four or more complete cycles per day, while for a real estate investor, a cycle can last 18 to 20 years.
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, real estate, bond, and commodity markets. The theory about this cycle states that economic sacrifices are generally made during the first two years of a president’s term. As elections approach, administrations have a habit of doing everything possible to stimulate the economy so that voters go to the polls with jobs and a sense of economic well-being.
Interest rates are generally lower in an election year, so experienced mortgage brokers and real estate agents often advise clients to schedule mortgages to expire just before the election.
The stock market has also benefited from increased spending and lower interest rates before the election, as it certainly did in the 1996 and 2000 elections. Most presidents know that if voters are unhappy with the economy when they go to the polls, the chances of re-election are slim or nil, as George Bush Sr. learned the hard way in 1992.
Although it is not always obvious, cycles exist in all markets. For smart money, the accumulation phase is the time to buy because the values have stopped falling and everyone else is still bearish. These types of investors are also called opposites, as they go against common market sentiment at the time. These same people sell when the markets enter the final margin stage, which is known as a buy or parabolic climax. This is when stocks are rising the fastest and sentiment is most bullish, which means the market is preparing to reverse.
Smart investors who recognize the different parts of a market cycle are better able to harness them to profit. They are also less likely to be fooled into buying at the worst possible time.