Market bubbles are a fact of life and there are lessons to be learnt from this. A bubble is only one part of an important phase in markets, so if you want to avoid being caught off guard, it is essential to know what the different phases are.
An understanding of how markets work and a good grasp of technical analysis can help you recognise market cycles.
There are four phases in every market cycle. No matter what market you are referring to, all have similar characteristics and go through the same phases.
The problem is that most investors and traders either fail to recognise that markets are cyclical or forget to expect the end of the current market phase.
An understanding of cycles is essential if you want to maximise investment or trading returns. Here are the four major components of a market cycle and how you can recognise them:
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 onver. Valuations are very attractive.
General market sentiment is still bearish . 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.
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.
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 occur. But the cycle is nearing the top of the bubble. Sentiment moves from neutral to bullish to downright euphoric during this phase.
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.
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. 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 break-even or a small loss.
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 per cent 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. But mostly, it is new investors who will buy the depreciated investment during the next accumulation phase and enjoy the next mark-up.
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 you are looking at.
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 18-20 years. Although not always obvious, cycles exist in all markets.
For the smart money, the accumulation phase is the time to buy since 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 sentiment is 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.