Cycles are everywhere around us, from the shifting seasons to the ebb and flow of the economy. Each is propelled by distinct forces and consists of distinct stages. In the movement of stocks, there are cycles and phases, and knowing their dynamics will help you spot future trading and investment opportunities.
Identifying the phases of the stock cycle will also assist you in developing patience. Patience can be a valuable asset in the financial world. It will prevent you from selling a stock too soon after bad news because you’ll know where it’s at in the cycle and won’t be tempted to sell it on a bad day. It could also help you from buying too much on a dip, or “trying to catch a dropping knife,” as traders call it.
“You have to be careful as a long-term investor with all the noise,” says JJ Kinahan, chief market strategist at TD Ameritrade. “You must understand why you entered into an investment and how to ensure that the investment is successful. Have a time period in mind, and determine whether you bought in to take advantage of earnings or because you believe the business would rise at a rate of 5% per year, allowing you to receive dividends. As an investor, you must have a strategy in place from the moment you start.”
Stage 1: Accumulation
Individual stocks, markets, or the market as a whole can all be seen in this point of the cycle. It’s distinguished by meandering, sideways price behavior that stays within a range and can last for months or even years.
This is when “smart money” (in the form of institutional investors) starts to buy shares. There are big players who need to buy a lot of stock but can’t do it all at once for fear of pushing up costs and increasing their cost of capital. As a result, they buy at regular intervals when the stock reaches their target price. This strengthens the stock and pushes it higher. Then they restart the process after the move has been digested and the price has returned to their goal amount.
Few retail investors can participate at this point because the price action is unremarkable and does not attract attention. Long-term investors, on the other hand, will be able to position themselves to reap the greatest benefits. However, you do not want to dive right in.
“Think about scaling into or out of positions to profit from price movements,” Kinahan advises.
If you buy all at once, you risk missing out on a better deal the next day or week. It’s possible that a “bite-sized” solution would be more effective than biting off a large chunk all at once. However, keep in mind that it will almost certainly increase the transaction costs.
Stage 2: Revisions
The markup stage is defined by price rallying above the resistance level, just as the accumulation stage is defined by support and resistance levels containing the price action of a stock. There will almost certainly be a surge in volume as this “breakout” occurs. Institutions and individuals who did not buy during the accumulation stage have jumped into the stock, causing this.
Price action will shift from neutral to trending during this point. After a price breakout, higher highs and higher lows may be an indication that the markup stage has started. This form of movement will draw interest, and as more buyers join the stock, the uptrend usually strengthens, eventually becoming parabolic before moving on to the next level.
At times like this, it’s best to be careful and make sure you get the stock you want at the price you want. Simple moving averages could be used to track main support and resistance levels.
Kinahan suggests putting a buy order just above support levels. “If a stock falls below a support level, an order placed at that price will not be filled. Any investors would rather spend a few cents than risk missing out entirely.”
If things don’t go your way right away during this moment, or at any other point in the cycle, don’t stray from your trading plan.
“Sometimes when you’re investing, you expect a change to happen right away and it doesn’t,” Kinahan says. “When a business introduces a new product, the initial reaction may be negative. However, if you’re a true believer, it may take some time. You may want to stay a little longer.”
Stage 3: Distribution
This is when a stock, a business, or the market as a whole has reached its peak. It indicates that a rotation is taking place, as both early and later buyers—those who purchased during the accumulation stage—may be leaving the stock.
This stage is characterized by an increase in volume without an increase in price. Since bullish optimism is extremely strong, this stage also sees the stock’s highest volume. New buyers may be able to absorb some of the sale at first, but not enough to keep the stock moving higher. The stock might potentially collapse under its own weight in this scenario.
Chart patterns like a head-and-shoulders top or a double top will help you recognize this point. A break below the 200-day moving average may also be a sign that the distribution process is coming to an end.
Stage 4: Markdown
This is the final stage of the cycle, and many investors would like to stop it. Buyers who entered during the distribution process and are now underwater on their positions begin to sell at this stage. There are very few new investors to absorb the increased sale, which may attract even more selling, since all of the institutional players have long since left.
This cascading impact has the potential to drive prices down dramatically and on a wide scale. When a critical support level is breached and volume spikes several times the regular average, most net selling is depleted and the stock will return to the accumulation stage.
Examine the past chart behavior of different stocks on a weekly time frame if you want to learn how to recognize these four levels. You’ll be able to recognize the possible signs of each stage with enough practice.
Patience and discipline, on the other hand, are entirely up to you.
Investing in the stock market entails a number of uncertainties, including the potential loss of principal.