“The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.”
— Seth Klarman
Market Cycles, also known as stock market cycles can be defined as the periods of growth and decline in a market sector or industry. In other words, market cycles refer to the visible price movements that rise, fall and return to their point of origin. Every market cycle goes through the same cycle, i.e. rising in the beginning, peaking (culminating) at the top before dipping, and bottoming out in the end. As the name indicates market cycles are cyclical, and the end of one cycle represents the start of a new cycle.
Expressed as time-series data, market cycles guide analysts and policymakers in decision making and enable traders to determine the best prices at which they can trade. Understanding the market cycles and knowledge of technical analysis can help us easily recognize and capitalize from these cycles. The basic principle of investing a trader should keep in mind remains Buy Low and Sell High.
Richard D. Wyckoff was one of the titans of Technical Analysis during the early 20 century and an active trader. His Price Action Market Theory is still a leading principle in today’s trading practice. According to the Wyckoff method, the price cycle of a traded instrument consists of 4 phases – Accumulation, Markup, Distribution, and Mark-Down. Let us now look at each of these phases in detail.
i. Accumulation: This is the first phase of a market cycle that occurs after the market has bottomed out in the previous cycle. With an increase in the institutional demand, prices find it difficult to hit new lows and the downward trend slowly loses its momentum. This is considered to be the best time to buy in stock markets as the prices remain low and a reversal trend is about to start. During this phase, experienced traders and corporates start buying sensing the onset of this reversal trend.
ii. Markup: This is the second phase of the market cycle when the market starts consolidating. At this phase, the market which seemed stable for a while begins to move up, attracting more buyers. The emergence of a bullish price trend pushes the price to a new high. While early buyers start trading at the accumulation phase, traders take advantage of the upward trend while it lasts. Though we are likely to see media coming up with statements like the worst is over, history reveals that unemployment shall continue to rise as indicated by the reports of layoffs across various sectors in the past.
iii. Distribution: Distribution, which is the third phase of the market cycle, is one where the sellers dominate as this is when the sale of share begins. With the emergence of an equal number of buyers and sellers, the market tends to stay stable for some time and the bullish sentiment of the mark-up phase starts to disappear as the market is at its peak. At this stage investors who have not yet entered the market stay on the sidelines as the market sentiment begins to turn bearish. Once this stage is over, the markets tend to reverse their direction. This is considered to be an emotional phase as investors have a mixed set of feelings such as fear, hope, and greed.
iv. Mark down: This is the fourth and final phase of a market cycle which many traders try avoiding. At this stage, investors who came in during the distribution stage start selling their investments followed by many others (mainly the public) to gain profits. With the fall in prices, the market sentiments turn increasingly bearish. Some investors who entered the market when the prices were at the peak hold on to their investments expecting the price to rise further, but unfortunately the prices continue to fall giving rise to an opportunity to buy for those who identified the end of the downward trend earlier. With this, the accumulation stage begins giving rise to a new market cycle.
There are numerous examples of financial market cycles in the history of financial trading. The 1990 rise in markets following the massive boom in spending and productivity due to the rise of the baby boomer generation is a popular example. Moreover, new technologies, like the Internet, along with a high level of debt that occurred as a result of low interest rates played their part in it. At a later stage, a rise in the interest rates brought about a mini-recession causing the market to turn bearish. A rise in the market was followed by the 2007 housing bubble and its subsequent market crash.
To conclude, we can say that understanding the market cycles is important for traders worldwide because it allows them to capitalize from trading stocks, commodities, and currency markets. This is even more important for traders of derivatives who look to profit from both positive and negative price actions, which are characteristic of market cycles.
“Watch the product life cycle, but more important, watch the market life cycle”- Philip Kotler
Idea & Concept: Ajith C J, Research Analyst (Technical & Derivatives)/Faculty
Content Development: Aswathi Satish , Niyog Consultancy Services Pvt. Ltd.