The financial markets can seem utterly unpredictable but, in reality, they move in four distinct phases. Understanding how each phase works makes the difference between floundering and flourishing.
Knowing the risks of each cycle equips you to avoid them.
Key Takeaways
- In the accumulation phase, the market has bottomed, and early adopters and contrarians see an opportunity to scoop up bargains.
- In the mark-up phase, the signs of recovery are clear, and more investors jump back in.
- In the distribution phase, sentiment turns mixed, sellers prevail, but others hang on hoping for bigger gains.
- In the mark-down phase, the laggards may sell to salvage what they can, but the contrarians aren’t buying until they see clear signs of a bottom.
The 4 Phases of a Market Cycle
Whether you’re considering stocks, bonds, or commodities, every market goes through the same four phases again and again. They rise, peak, dip, and then bottom out. When one market cycle is finished, the next one begins.
The problem is that most investors and traders either fail to recognize that markets are cyclical or forget to anticipate the end of the current market phase.
Even when you accept the existence of cycles, it is nearly impossible to pick the top or bottom of one.
Still, an understanding of cycles is essential if you want to maximize your returns. Here are the four major components of a market cycle and how you can recognize them.
1. Accumulation Phase
This phase begins after the market has bottomed and the innovators (corporate insiders and a few value investors) and early adopters (smart money managers and experienced traders) start to buy, figuring the worst is over.
At this phase, prices are very attractive, and general market sentiment is still bearish. The media are preaching doom and gloom, and those who were long through the worst of the bear market have given up and sold their holdings in disgust.
However, in the accumulation phase, prices have flattened. For every seller throwing in the towel, there is an investor ready to pick it up at a healthy discount.
Finally, overall market sentiment begins to switch from negative to neutral.
2. Markup Phase
At this stage, the market has been stable for a while and is beginning to move higher. The early majority are getting on the bandwagon. This group includes technicians who, seeing the market is putting in higher lows and higher highs, recognize market direction and sentiment have changed.
The media begin to discuss the possibility that the worst is over but unemployment is continuing to rise, and there are still reports of layoffs in many sectors. As this phase matures, more investors jump on the bandwagon as fear of being in the market is supplanted by greed and the fear of being left out.
Late in this phase, the last holdouts jump in and market volumes begin to increase substantially. At this point, the greater fool theory prevails. Valuations climb well beyond historic norms, and logic and reason take a back seat to greed.
When the latecomers get in, the smart money and insiders start unloading.
Prices begin to level off, but those laggards who have been sitting on the sidelines think this is a buying opportunity and jump in en masse. Prices make one last parabolic move, known in technical analysis as a selling climax. This is when the largest gains in the shortest periods often happen.
But the cycle is nearing the top. Sentiment moves from neutral to bullish to downright euphoric.
3. Distribution Phase
In the third phase of the market cycle, sellers begin to dominate. The bullish sentiment of the previous phase turns into a mixed sentiment. Prices often stay locked in a trading range that can last weeks or even months.
For example, when the Dow Jones Industrial Average (DJIA) peaked in Feb. 2020, it traded down to the vicinity of its prior peak and stayed there for several months.
The distribution phase can come and go quickly. For the Nasdaq Composite, in the same period, the distribution phase lasted less than a month, peaking in February 2020 and moving 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 the kinds of movements that occur during the distribution phase.
The distribution phase is an emotional time for the markets, as investors are gripped by periods of complete fear interspersed with hope and greed as the market appears at times to be taking off again.
Valuations are extreme in many stocks and value investors have long been sitting on the sidelines.
Usually, sentiment begins to change slowly but surely, but this transition can happen abruptly 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 and they’re still hoping for rescue.
Half or more of these laggards will only give up when the market has plunged 50% or more.
Their capitulation 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 years. And, not every investor is looking at the same time frame. A day trader using five-minute bars may see four or more complete cycles per day. For a real estate investor, a cycle may 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 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, presidents have a habit of doing everything they can to stimulate the economy so voters go to the polls with 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. Most presidents know if voters are not happy about the economy when they go to the polls, their chances for re-election are slim to none.
What Is a Contrarian Investor?
A contrarian investor, as the name implies, moves in the opposite direction of the prevailing sentiment, buying when others are fleeing and selling when they pile in.
In the context of market cycles, contrarians buy when they perceive that prices have hit bottom and then sell late in the markup phase, when prices may be approaching their peak.
What Is a Value Investor?
The value investor’s strategy is similar to that of a contrarian. The value investor seeks to identify stocks that are currently underpriced relative to their real worth and future prospects. That approach can be taken in any market cycle.
What Are Cyclical and Non-Cyclical Stocks?
Cyclical stocks tend to move with the economic cycle, which is not identical to the market cycle although they certainly influence each other. Non-cyclical stocks, often called consumer staples, do well regardless of the larger trends.
For example, when the economy is in a recession, construction supplies may sell poorly because businesses aren’t expanding. The companies that sell these supplies are cyclical stocks. At the same time, people still buy toothpaste and heat their homes. The companies that sell staple goods and utilities continue to do well.
The Bottom Line
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 markup, 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 recognize the different parts of a market cycle are more able to take advantage of them to profit. They are also less likely to get fooled into buying at the worst possible time.
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