One of the defining traits of the stock market is that it repeats the same price action patterns over time. The ebb and flow of price is generally driven by supply and demand. These movements mirror the underlying human psychology of optimism, greed, panic and fear. Over time these movements create repeating patterns that constitute the general Market Cycle.
This can be better illustrated when we observe how a sailor sails through the high seas. Any decent sailor knows that smooth voyages are achieved when they align the sail to the direction of the wind. The wind carries them through with minimum effort. This same concept applies to stock trading. When a trader aligns their strategy to the market cycle, maximum profit is achieved and unintended losses are avoided.
The Four Major Market Phases
The market generally cycles around four major phases. How fast it transitions from one phase to another will heavily depend on current global and local economic conditions.
1. Accumulation
Investor/Trader Stance: BUY
Period of consolidation with stable volatility. Institutional accumulation begins during this phase.
Accumulation phases happen after every major or minor market crash. During this time, most traders have given up and recurring bearish news circulate. However, it is during this time that the economy starts to recover and financial institutions start accumulating shares at discounted prices.
2. Mark-Up
Investor/Trader Stance: HOLD
Period of bullish market sentiment. Economic performance is strong thus prompting increased appetite for risk. Institutional buying spikes as a result.
Mark-up phases are the peak of economic growth and optimism. Traders are aggressive and demand is at an all time high.
3. Distribution
Investor/Trader Stance: SELL
Period of profit taking. When growth targets are reached and no strong catalysts are in sight, institutional investors start to look for more profitable markets.
During distribution phases, institutions who have accumulated prior the market rally are gradually selling into strength. This increase in selling activity prevents the price from rising further, thus a sideways move happens.
4. Capitulation
Investor/Trader Stance: FULL CASH POSITION
Panic selling phase. Exodus of institutional investors cause big sell offs that lead to market breakdown. What triggers institutional selling differs each time.
Capitulation phases are a domino effect of many market participants selling at the same time. This is usually triggered by some local or global news or event that have severe impact on the economy. As investors become fearful, they sell at any given price and remain in cash in the short term.
Aligning to the Market Cycle
Each phase of the market cycle highlights specific investor/trader behavior. The ideal approach is to slowly start accumulating shares during the Accumulation phase and average up as the market rallies during the Mark-Up phase.
As your positions compound in profit, you want to watch for any sign of bearish market reversals. Once these reversal patterns appear in the chart, this may point to a market transition to the Distribution phase. You may start selling in this phase as any short-medium term trader wants to be in full cash position before the market retraces back down.
This is of course easier said than done. Properly aligning trade executions to the market cycle requires a firm grasp on technical analysis. The better you can interpret the charts, the more accurate you will be in terms of navigating each market cycle.
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