However investors still need to be aware of which phase we are in to ensure they are not taking undue risk in an investment. 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 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 five major components of a market cycle and how you can recognize them:
1. The 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 that the worst is over. Valuations are very attractive. 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 capitulated, that is, given up and sold the rest of their holdings in disgust. But 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.
2. The 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 that the market is putting in higher lows and higher highs, recognize that 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 lay-off's 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.
3. The Greed or Late Majority Phase
During this stage, the late majority jump in and market volumes begin to increase substantially. At this point, 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 occur. But the cycle is nearing the top of the bubble. Sentiment moves from neutral to bullish to downright euphoric during this phase.
4. The Distribution Phase
In this phase, 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. But the distribution phase can come and go quickly.When this phase is over, the market reverses direction. Classic patterns like double and triple tops, as well as head and shoulders top patterns, are examples of movements that occur during the distribution phase. It is here we see market breadth such as our Advance/Decline line, weakening. 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. No timing models are flashing BUY signals. 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.
5. Mark-Down Phase
The 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 that the laggards, many of whom bought during the distribution or early mark-down phase, give up or capitulate. Unfortunately, this is a buy signal for early innovators and a sign that a bottom is imminent. It is new investors who will buy the depreciated investment during the next accumulation phase and enjoy the next mark-up.
It is important to understand more or less which phase we are in, and the psychology behind each. Your investment strategy may change from one phase to another. Calling the exact beginnings and ends of these phases is difficult. Each phase becomes more dangerous and offers less margin of safety than the next. Many of us stay in the markets after all the timing signals have flashed their SELLS, to extract the last gasp returns of the bull market, but the investment style here is different as you have to have tight stop losses and monitor the markets constantly.
Source: Edited Article from powerstocks.co.za