The general fluctuations of the stock market may be viewed as a cycle that repeats and has four distinct stages. Investors may make longer-term investing decisions that are more informed by having a better understanding of this cycle.
What is the Market Cycle?
Since stock market prices are a reflection of the economic well-being and profitability of public firms, their value should fluctuate with the general business and economic climate that those corporations are subject to. The economic cycle, which frequently shifts from times of growth to contraction again, is understood to represent how that environment changes through time in a cyclical fashion.
Expansion, peak, recession, and trough are the four stages that are frequently used to define the economic cycle. While it is possible to demonstrate that these stages have occurred repeatedly throughout history, both their frequency and size rely on a wide range of economic factors, including interest rates, employment, trade imbalances, monetary policy, tax policy, and many more.
These elements range widely.
How Are Market Cycles Formed?
Economic cycles can be caused by a variety of factors. Among them are:
Access to credit in the labor market varies
- difficulties pertaining to money or interest rates
- variations in supply and demand
- new technology’s emergence or its obsolescence
- Businesses, financial organizations, governments, and individuals all display patterns of growth and contraction that evolve through time in reaction to these changes.
The stock market may predict changes in the economy up to six months in advance due to its inherent forward-looking character. As a result, over time, the market changes depending on where investors believe the economy is heading, and investors can behave more erratically than the economy. In addition to the economy, the geopolitical environment is another factor that influences investor sentiment toward stocks.
Identifying The Phase Of The Market Cycle & What That Means For a Portfolio
Numerous data must be gathered, measured, and compiled in order to accurately estimate the status of the economy at any given time. Therefore, until after the event, no one can tell with certainty when a certain economic era has finished. Additionally, certain contributing elements might alter independently from one another, leading the market to momentarily deviate from the economy. Because of this, even the most eminent economists frequently struggle to predict with precision where the economy is heading at any one time.
However, even without such accuracy, we can typically determine which phase we are in and, consequently, which phase we will enter next. Just how soon or exactly when
4 Stages of a Market Cycle
A conceptual diagram of the market and economic cycles is shown below.
1. Accumulation Phase
Early purchasers include business insiders, value investors, and people who were lucky enough to obtain capital during the collapse. The accumulation phase comes after a decline that may have been severe and still has its aftereffects. In this stage, prices are appealing in comparison to historical levels, but caution persists and the mood is still pessimistic.
Many individuals only lately capitulated, incurring losses they could no longer be patient with. The media still reports on the prior downturn.
2. Mark-up Phase
When that threshold is reached, the general consensus is that a bottom has been reached. Now that the market has changed, individuals are starting to really buy. Assisted by proven uptrends and rising moving averages, market technicians enter the trade. Additionally, FOMO (fear of missing out) and greed are back. The focus of media articles shifts to those industries that have recovered and have resumed predicting new highs.
The justification for valuation expansion is that “It’s different this time.” The smart money is pleased to sell to the latecomers as they swarm in.
3. Distribution Phase
The distribution phase has the early buyers selling to the latecomers as volume is high, but the price has difficulty advancing any further. Price can be subject to sharp declines and recoveries or a rolling top, but the highs remain in place. Distribution is usually the shortest phase and might only last weeks or months compared to advances that likely took years.
In the final stages of the advance climb, a wall of worry and overconfidence convinces many participants that they can keep buying until they see the turn and will know to get out quickly. Technicians will point to possible topping patterns and deteriorating market fundamentals, but many will keep buying anyway. The number of stocks setting new highs diminishes and a handful of notables carry the day. Meanwhile, prices hit new highs as if that’s what they’re supposed to do.
4. Decline Phase
When consumers know the top has happened, the downward phase is typically already well underway, but loss aversion will keep many from selling. Some people may try to grab the falling knife for a deal, but they will soon find that the bottom is still not in.
Business Cycles vs. Market Cycles
Since business and economic cycles influence the fundamental health of organizations and foretell their future prospects, stocks should, in principle, reflect these cycles. However, in practice, the differences rather than the similarities between the stock market and the economy are more frequent. One reason is that investors purchase stocks is for their potential future value, which is typically many months or even years in the future. Additionally, investors might easily alter their opinions if news events startle them.
Another factor is investor sentiment as a whole, which varies in only sporadic concord with the fundamentals. Stocks frequently respond favorably or negatively to economic news, but correlations across weeks or months are now rarely perceptible.
To put short-term events in perspective and determine whether or not they will have an impact on the market, it is crucial to have a fundamental understanding of economic and market cycles. Although the cycles won’t provide you with immediate trading indications, they will provide you a longer-term perspective that should help your entire investment plan.