Phases of Stock Market Cycle
Similar to the phases of an economic cycle, there are phases of the stock market cycle. Let us discuss in this section.
The stock market and the economy have a fascinating relationship; the two are not one and the same. Stock markets also move in cycles and have distinctive phases. The stock market and its cycles always move in advance of the economy i.e. it is a leading indicator of economic activity.
Let's take the market crash of 2020 as an example. During that point in time, all the key indicators revealed that the economy worldwide has gone for a toss due to incessant lockdowns and is not in a good shape at all. In spite of that, the global equity market has largely been buoyant and moving on an upward trajectory on account of better-than-expected corporate earnings in the coming quarters and on expectations of supportive tax reforms and aid by the government.
It is a must to be aware about stock market cycles to get a whiff of the market direction and the suitable macro as well as micro asset allocation strategy to be used.
The stock market cycle can be broadly divided into four phases.
This phase of the stock market shall occur after the market reaches its bottom. At this stage, Insiders, value investors and few experienced mutual funds begin to buy, judging that the worst is over. Valuations at this phase are very attractive. However, general market sentiment is still bearish.
Mark up phase
During this stage, the market is stable and gradually starts to move higher. Smart technical analysts recognize the market direction and identify that the market is making higher highs and higher lows. Sentiments gradually change towards positivity. Media stories begin to discuss the possibility that the worst is over. As this phase matures more investors jump in. Predominantly, emotions like greed steps in and fear is eliminated amongst the investors and traders.
This is the third phase of the stock market and here the sellers begin to dominate the market. There are a considerable number of sellers who enter the market and arrest the upward momentum. Typically, prices move in a narrow sideways range during this period. The strong hands who had entered during the accumulation & mark-up phase cash out on their profits.
Mark down phase
The mark down is the final phase of the market cycle. The selling by strong hands spills over to the broader market as the excess supply becomes too much to cope with. With prices following a downward trajectory, the market sentiment gets bearish. Some investors who entered the market when prices were at their peak may hold on to their investments with the hope that the prices will rise again. Emotions such as fear and hope dominate this phase. Unfortunately, prices continue to fall and this provides a buying opportunity for investors who are able to identify the end of the downwards trend. And hence, the cycle starts all over again.
It is important to identify which phase we are in and the psychology behind each phase. Our trading and investment strategies depend on them.