Friday, July 3

Markets Cycles: What They Are and How to Trade Them?

Reading Time: 8 minutes

All traders are human beings (remember that there is still no robot that can consistently provide positive results in trading). Human psychology, therefore, plays an important role in any financial market, be it stocks, bonds, currencies or commodities.

Economic cycles, that correspond to the periods of higher and lower prices, vary in nature. Some of them can be attributed to market psychology. Here is how they work. When an ever-increasing number of people enter a particular market with a long position, be it Bitcoin in 2017 or the IT industry in the late 90s, the price can be expected to demonstrate a steady growth with little to no retracement. As a result, an illusion of never-ending growth is created. What follows next is a full-blown hysteria. In the 90s, a lot of well-known investment experts dubbed IT as “the only industry that still deserves your money”. The same happened to Bitcoin back in 2017. When the price of a particular asset demonstrates triple digit gains, in the eyes of certain experts it suddenly becomes the Holy Grail of trading. Yet, in reality it is just the opposite. The faster the growth, the higher the probability of a sudden crash. Bitcoin and the dot-com bubble are not exceptions. It is, therefore, wise to consider a diversified portfolio.

Bullish phase of the market cycle

When the asset price (be it equity, commodity, cryptocurrency or anything else) gets blown too far away from its intrinsic — in other words, real — value, the countdown begins. Sooner or later, the market will demonstrate that there is no growth potential left, and the wise will start pulling their money out of the asset.

The same applies to the periods of economic downfall. The general public (that is mostly responsible for the market psychology phenomenon) is too eager to sell when the asset price begins to plummet. What constitutes a lucrative opportunity to buy low for a professional, becomes a bloodbath for unprepared traders.

Bearish phase of the market cycle

It is hard to avoid the temptation of keeping that profitable position just a little bit longer, and of course you do not have to close long-term positions all at once. Yet, it is important to estimate future growth prospects. By estimating the target price, support and resistance levels, you can get a better understanding of how much steam is still left in the asset you are trading. In other words, you don’t have to believe in a particular asset, you have to thoroughly and calmly evaluate its real potential.

The same logic applies to shorter timeframes, as most technical analysis indicators take principles of mass psychology into account. What rises should fall, and what falls should rise again. By predicting the market sentiment, you would be able to predict the behavior of other traders and, consequently, the price of the asset. It may sound cheesy but in order to trade successfully, you have to think like other people and predict their actions. And this is where market psychology comes into play…

Market Cycles: The Key to Maximum Returns

We’ve all heard of market bubbles and many of us know someone who’s been caught in one. Although there are plenty of lessons to be learned from past bubbles, market participants still get sucked in each time a new one comes around. A bubble is only one of several market phases, and to avoid being caught off-guard, it is essential to know what these phases are.

An understanding of how markets work and a good grasp of technical analysis can help you recognize market cycles.

4
The number of phases in a market cycle; they are accumulation, mark-up, distribution, and mark-down.

The Four Phases of a Market Cycle
Cycles are prevalent in all aspects of life; they range from the very short-term, like the life cycle of a June bug, which lives only a few days, to the life cycle of a planet, which takes billions of years.

No matter what market you are referring to, all go through the same phases and are cyclical. 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 expect the end of the current market phase. Another significant challenge is that even when you accept the existence of cycles, it is nearly impossible to pick the top or bottom of one. But an understanding of cycles is essential if you want to maximize investment or trading returns. Here are the four major components of a market cycle and how you can recognize them.

KEY TAKEAWAYS
Markets move in four phases; understanding how each phase works and how to benefit is the difference between floundering and flourishing.
In the accumulation phase, the market has bottomed, and early adopters and contrarians see an opportunity to jump in and scoop up discounts.
In the mark-up phase, the market seems to have leveled out, and the early majority are jumping back in, while the smart money is cashing 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 mark-down phase, laggards try to sell and salvage what they can, while early adopters look for signs of a bottom so they can get back in.

  1. Accumulation Phase
    This phase occurs after the market has bottomed and the innovators (corporate insiders and a few value investors) and early adopters (smart money managers and experienced traders) begin to buy, figuring the worst is over. At this phase, valuations are very attractive, and general market sentiment is still bearish.

Articles in the media preach doom and gloom, and those who were long through the worst of the bear market have recently given up and sold the rest of their holdings in disgust.

However, in the accumulation phase, prices have flattened and for every seller throwing in the towel, someone is there to pick it up at a healthy discount. Overall market sentiment begins to switch from negative to neutral.

  1. Mark-Up 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.

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 fear of being in the market is supplanted by greed and the fear of being left out.

As this phase begins to come to an end, the late majority 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. While the late majority are getting in, the smart money and insiders are unloading.

But as prices begin to level off, or as the rise slows down, those laggards who have been sitting 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 largest gains in the shortest periods often happen. But the cycle is nearing the top. Sentiment moves from neutral to bullish to downright euphoric during this phase.

  1. 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 of the previous phase turns into a mixed sentiment. Prices can often stay locked in a trading range that can last a few weeks or even months.

For example, when the Dow Jones Industrial Average (DJIA) peaked in Jan. 2000, it traded down to the vicinity of its prior peak and stayed there over a period of more than 18 months.1 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 March 2000 and retreated shortly thereafter.2

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 10 years old and is the longest-lasting bull run in history, with the S&P 500 higher by over 300% since hitting multi-year lows in March of 2009. After sliding at the end of 2018, it could be primed for an 11th year, depending on the outlook for the economy. But a recent spate of big selloffs and topsy-turvey trading has raised concerns that it could be losing steam.

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.

  1. 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.

Figure 2: Weekly chart of Applied Materials (AMAT) from late 1998 to early 2004 showing different market phases and one cycle of mini-phases with 10-week (purple line) and 50-week (orange line) moving averages.

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. This strategy has worked quite well during the last 16 years.

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.3 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.

Summing Up
Although not always obvious, cycles exist in all markets. For the 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 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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NOTE: This article is not an investment advice. Any references to historical price movements or levels is informational and based on external analysis and we do not warranty that any such movements or levels are likely to reoccur in the future.
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