People often view stock market trends as linear movements on a chart over time. However, a closer examination of any period in market history reveals that the market actually moves cyclically. This pattern, known as the market cycle, involves repeated phases of buying and selling on a large scale.
Understanding these market cycles, their phases, the influence of investor emotions, and how to incorporate this knowledge into your investment strategy can be invaluable for any investor.
The Four Stages of the Market Cycle
Market cycles can refer to any market, such as stock markets, real estate, or bonds. However, this discussion focuses primarily on the stock market. It’s crucial to distinguish between the stock market and the economy, as they are not the same. While the economy measures broader economic health through metrics like GDP, the stock market assesses the health of publicly traded companies. Historically, economic cycles tend to last longer than market cycles.
Each market cycle includes four stages: accumulation, markup, distribution, and markdown. Terms like “bubble burst,” “crash,” or “recovery” refer to different phases of this cycle. Let’s explore each stage in detail, along with the associated investor sentiment.
Accumulation (Early Cycle)
The accumulation stage occurs immediately after the market hits the “rock bottom” of a downturn. During this period, large institutional investors often see opportunities to buy shares at discounted rates. They purchase stocks gradually to avoid driving prices up too quickly. They buy when prices are desirable, wait for market reactions to settle, and repeat the process. Individual investors may also start buying more positions, though on a smaller scale.
Investor Sentiment: Investors and money managers begin to test the waters, betting that the worst is over. General sentiment is not particularly negative but remains fairly neutral, indicating that a bear market may still be in place.
Markup (Mid Cycle)
During the markup phase, the market follows a stable upward trajectory. More investors, including those previously hesitant, start buying shares on a large scale, believing the market is recovering. Valuations rise, and this period often sees the largest gains in the shortest time. The market may approach its peak.
Investor Sentiment: As the mid-cycle stage progresses, investor excitement grows. Toward the end of this stage, investors may abandon reason and logic, driven by greed and FOMO (fear of missing out). Big losses seem distant, and herd mentality leads more investors to join the buying frenzy. Sentiment shifts from neutral to highly bullish.
Distribution (Late Cycle)
As the market peaks, upward momentum stalls. Early investors typically sell off their positions. Major selloffs can be triggered by significant geopolitical events or economic indicators, such as wars, pandemics, or housing market crashes. For instance, the news of COVID-19 in March 2020 led to widespread panic and massive selloffs.
Investor Sentiment: Excitement fades, and investors become unsure about the market’s direction. Sentiment shifts from bullish to mixed emotions, with some investors feeling fear.
Markdown (Decline)
During the decline phase, more investors panic-sell based on recent events or poor forecasts, causing prices to trend downward. This phase is the most painful for investors still holding positions. Stock values often fall below purchase prices, and institutional investors may have already sold their shares. More people sell than buy, leading to large-scale price drops.
Investor Sentiment: Sentiment swings to the negative end, with many investors experiencing significant losses. Those who cannot endure further losses sell off their positions, often at a loss. However, some savvy investors, understanding the cyclical nature of markets, may be ready to buy shares at depreciated prices.
Conclusion
Understanding the market cycle and its stages is crucial for any investor. Recognizing the signs of each phase and the associated investor sentiment can help you make informed decisions and navigate market volatility more effectively. By incorporating knowledge of market cycles into your investment strategy, you can better position yourself to take advantage of opportunities and mitigate risks.