Anyone who has invested in stocks for a while will know that the market goes through cycles, not just ups, and downs but distinct phases that repeat. You might also have noticed that certain assets perform better during different market phases. So if you are caught holding assets that do not perform well when the market cycle shifts to a new phase, then you suffer losses. This prompts the question, what are the stock market cycles, and if I could find a stock market cycle indicator could I use this to shift into different assets to benefit from a new market cycle.
Stock market price fluctuations
What drives prices up and down? The simple answer is supply and demand. If there is more demand than supply that drives prices up if there is more supply than demand that drives prices down.
It is easy to be bewildered by prices moving constantly up, down, and sideways. It can be more daunting when you are trying to work out when to get in or get out and knowing that there are other traders and investors out there all trying to outwit each other and to outwit you.
When asked by a young investor what he thought stock prices would do, J. P Morgan famously said,
“They will fluctuate, young man, they will fluctuate.”.
As explored in this other article, one of the main assumptions of technical analysis is that price fluctuations follow discernible patterns. There are indicators that can reveal when a current cycle is about to move into another phase, these are called leading indicators.
There are also indicators that confirm what just happened and that it is continuing to happen in the markets. These are called lagging indicators.
Stock market cycles and economic cycles
The stock market goes through its cycles and the economy follows through similar cycles. It is a well-established observation that stock market growth precedes economic growth and a stock market decline precedes an economic recession.
When the stock market tips into a prolonged downtrend that’s an indication that a recession is on the way. Conversely, a confirmed bull market rise in the stock market will start before a recession has ended and will likely be followed by economic growth.
That’s great if you are in business trying to decide whether the economy will be favorable for a new venture or product launch but it’s frustrating if you are an investor or trader wondering what moves to make in the market.
Money and emotions
There are four distinct phases that can be identified. Each phase has a distinct price behavior and at the same time is characterized by an emotional counterpart. The price behavior and emotional counterpart feed into and react to each other.
The first person to document a theory of market price cycles was Richard Wyckoff way back in the late 19th century and early 20th century. He noticed four distinct phases, accumulation, markup, distribution, and markdown. Here is what Wyckoff’s model looked like.
As the chart shows, prices move between levels of support and resistance during each phase. After testing the levels of resistance a few times buyers gain the upper hand and the price breaks through from the accumulation phase to the markup phase.
A similar pattern is seen at the end of the distribution phase, after testing support levels a few times, sellers eventually win and breakthrough and the markdown phase starts.
Who drives the market?
There is an important fact to remember.
The public mood that characterizes each phase is an experience shared broadly by many. However, somewhere around 80 percent of the trading volume in the market is due to large institutional investors. Whatever the institutional investors are doing drives what happens in the market and there isn’t much that small investors can do to influence matters.
The best the small investor can hope for is to gather some crumbs that may fall from the banquet table where the institutions are feeding.
If that invokes images you may have seen in movie versions of Charles Dickens Oliver Twist when the hungry orphans look longingly at the board of governor’s dining table – sorry for the melodrama but that’s about right.
The Wyckoff market cycles explained
Accumulation – the accumulation phase starts after the market has reached bottom following a decline that has wiped out everyone who is selling out. At the very market bottom, the predominant emotion is despondency.
The early buyers entering at the accumulation phase are the smart money investors. The public mood shifts from despondency to depression still not ready to believe in the price upswing as the dominant stories in the media are about the ongoing recession.
At some point with mounting evidence of rising prices, the media takes more notice and reports the end of the recession. Wyckoff theorized that there is a big selloff where the last sellers give up and sell out. That is a spring point that looks like a break to even lower prices but actually buyers are winning.
The cycle moves into the next phase and the public mood shifts from depression to hope.
Markup – as media attention reinforces the perception that the recession is clearly over, the economy is growing, the bull market is in full swing, the public mood transitions from hope through relief and then into optimism.
Most of the money now entering the market is institutional investors getting back in or building themselves stronger positions. Now we are really in a solid bull market. Optimism becomes excitement and prices continue their relentless climb.
Eventually, we approach the end of the markup phase. The overwhelming evidence of prices going ever higher turns excitement into thrill, now many smaller, new, and less experienced investors start jumping into stocks trying to not miss the boat.
The public mood of thrill gives way to euphoria. Most of the smart money will have left by now. Finally, all the indicators show that the market is overbought and the big institutions decide that the bull market has run its course even though the economy is still growing.
Distribution – as the sellers take over they start to dominate the market. Again like at the end of the accumulation phase there is one final buying spurt but the big institutional money is selling so the distribution phase tips the market into a downtrend. Euphoria is replaced by anxiety.
Markdown – The full bear market is now confirmed. Sellers still dominate and drive prices even lower. Small and inexperienced investors who bought in during the bull market are wondering what they got themselves into.
This is when a big selloff comes. Ever declining prices push the general mood from anxiety through denial, then fear, and later desperation. Some small investors are still holding on but prices continue to push lower.
Desperation finally gives way to capitulation and the last of the small and inexperienced investors sell out. By the end of this phase, everyone who is selling eventually sells right at the bottom.
At this point when the bottom is reached, the sellers have run their course. All the indicators are showing that the market is oversold. Another phase of accumulation starts.
How long the cycles last
If we examine the historic data, taking the Standard and Poor’s 500 index as an indicator for the market, we see that bull markets last longer than the bear markets.
We should remember that a bull market is defined as a market that rises 20 percent from the previous low and a bear market is defined as a market that declines by 20 percent or more from the previous peak.
The bull market periods of rising prices last on average 6.6 years and achieve an accumulated 339 percent increase while the big bear market periods of declining prices last on average 1.3 years and experience a cumulative loss of 36 percent.
Here is what those bull and bear market periods look like on a timeline from 1926 to 2019.
A complete cycle
As we can see the public mood progresses slowly at first through the positive emotions but has much less time to adjust from the euphoria of a market peak to the capitulation close to the subsequent market bottom.
Bull traps and bear traps
Something else to notice on this chart is the clearly visible Bear Trap and Bull Trap which typically occur early on in the Markup and Markdown phases respectively.
Early on a bull market, there can be a correction in the form of a sudden price drop. This can be a trap to bears who misread the signal and start for example short selling the market. However, if the short-term price correction is reversed and the market continues on the uptrend and short sellers will lose.
A similar situation can arise in a bear market. Early on there can be a short correction and prices suddenly rise again. This can be a trap for bulls who may be tempted to reenter the market taking new long positions. If the general downtrend continues the bulls will find themselves on the wrong side of the market.
Where are we right now
This is where we think we are right now in early June 2020.
To the question of where are we now – in June 2020 – Are we in a markdown phase or is it too early to say – I’d say the jury is still out.
On one hand, we know that the world economies are likely going to see difficult times ahead because of all the impacts of the coronavirus. We are likely to see recessions in many economies for the next few years.
On the other hand, there still seems to be investors in the market and central banks around the world are doing their best to learn the mistakes of the early 1930s and have drastically eased monetary policies.
I think this points to a period of price volatility and the rise we saw in April and May is looking more and more like a classic Bull trap.
Leading and lagging indicators
The stock market, housing starts, and consumer sentiment are considered leading indicators for economic cycles. Economic lagging indicators are the unemployment rate, interest rates, and business spending.
Leading indicators for the stock market
One of the most reliable leading indicators for the stock market was noticed by Joe Kennedy back in 1929. Mr. Kennedy was having his shoes shined and the young boy shining his shoes started to give him stock tips.
At that point, Mr. Kennedy realized he had to sell his stocks and leave the market fast because it had become too popular for its own good. He did just that and was able to avoid most of the carnage of the ensuing market crash.
Others have made similar observations in later years noting that when hot tip stock market investing becomes common conversational currency among the inexperienced public, that is a sign to pack up and leave like Joe Kennedy.
To find out more about stock market cycles, check here.
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