From the changing seasons to the ebb and flow of the economy, cycles are all around us. Each is driven by unique forces and made up of individual stages. Cycles and stages are also present in the movement of stocks, and understanding their dynamics can help you identify potential trading and investment opportunities.
Identifying stock market cycle stages can also help you develop patience. And in the financial marketplace, patience can be your friend. It can keep you from selling a stock too soon when bad news hits, because you’ll have a sense of where it is in the cycle and won’t be tempted to drop it on a rough day. It might also help you avoid buying too soon on a dip, or, in trader parlance, “trying to catch a falling knife.”
“Investing is full of noise and distraction,” said Alex Coffey, senior trading strategist for TD Ameritrade. “It’s important to have plan when making an investment, including entry and exit targets as well as time horizon. Having a plan can help an investor navigate the noise.” Of course, too much patience can be too much of a good thing. Patience can have its own risks, like waiting forever for a stock to turn around or buying more of a stock as the price keeps falling.
The four stages of a stock market cycle include accumulation, markup, distribution, and markdown. Let’s talk more about each cycle.
Stage 1: Accumulation
This is the first stage of the market cycle and can be found with individual stocks, sectors, or the market as a whole. It’s characterized by meandering, sideways price action that stays within a range and can last a long time, sometimes even for years.
This is the stage in which “smart money”—in the form of institutional investors—begins to accumulate shares. These are major players who need to acquire large positions but can’t do it all at once for fear of driving prices higher and raising their cost basis. So, they buy at regular intervals when the stock hits their desired price levels. This supports the stock and moves it up slightly. Then they wait for the move to be digested and the price to come back to their target level before repeating the process.
During this stage, few retail investors might participate because price action is unremarkable and doesn’t attract attention. On the other hand, this is where long-term investors might be able to position themselves to realize the greatest gains. But you may not want to jump in all at once.
“Investors should consider scaling in and out of positions. It doesn’t have to be all in or all out,” said Coffey.
Buying everything at once means you might miss out on a better price the next day or the next week. A “bite-sized” approach might work better than chewing off a big chunk all at once.
Stage 2: Markup
Just as the accumulation stage is characterized by support and resistance levels containing the price action of a stock, the markup market cycle stage is identified by price rallying above the resistance level. When this “breakout” happens, you’ll likely see a spike in volume. This is caused by institutions and individuals, who didn’t buy during the accumulation stage, jumping into the stock.
During this stage, price action can go from neutral to trending. If you begin to see higher highs and higher lows after price breaks out, it can be a telltale sign that the markup stage has begun. This type of movement can attract attention, and as more and more buyers come into the stock, the uptrend typically gets stronger, eventually becoming parabolic before entering the next stage.
Some investors may choose to be patient at such times and make sure to buy the stock at a better price if available. That might mean using simple moving averages to track key support and resistance levels.
“Most technical traders would consider placing a buy order just above a support level because they expect the stock to bounce there,” Coffey explained. “If their order was below the support level and the support holds, they may not get filled at all.”
During this stage, and really at any point in the cycle, don’t let yourself stray from your trading plan if things don’t immediately move your way.
“In an ideal world, what we think will happen happens, and happens right away,” Coffey said. “In investing, however, sometimes things take time, and that’s why having a plan for your investment is so important.”
Stage 3: Distribution
This is the topping stage for a stock, sector, or the market in general. It signals that a rotation is taking place as early buyers—those who bought during the accumulation stage—as well as later buyers may begin exiting the stock.
One hallmark of this stage is an increase in volume but without an increase in price. In fact, this stage often sees the stock’s highest volume because bullish sentiment is extremely high. Initially, new buyers may be able to absorb the selling, but not enough to keep driving the stock higher. In this scenario, the stock can actually collapse under its own weight.
A way to identify this market cycle stage is through chart patterns, such as a head and shoulders top or double top. A break below the 200-day moving average can also be a confirming signal that the distribution phase has ended.
Stage 4: Markdown (or decline)
This is the final stage of the market cycle, and the one that many investors want to avoid. At this point, buyers who got in during the distribution phase and are underwater on their positions start to sell. Because institutional players are long gone, there are very few new buyers to absorb the increased selling, which can attract even more selling.
This cascading effect can send prices down very rapidly and on large volume. This phase usually ends when a critical support level is breached and volume spikes many times the daily average, at which point most net selling is exhausted and the stock can return to the accumulation stage once again.
If you want to learn to identify these four stages, study the past chart action of various stocks on a weekly time frame. With enough practice, you’ll be able to identify the potential signs of each individual stage.
Patience and discipline, however, are up to you.
Investing in the stock market involves significant risks, including loss of principal.
Disclosure: TD Ameritrade® commentary for educational purposes only. Member SIPC. Options involve risks and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.