Market Cycle: Definition & Stages
The stock market’s overall movements can be described as a repeating cycle that has four identifiable stages to it. Understanding this cycle can help investors make more informed investment decisions for the long run.
What is the Market Cycle?
Since the level of stock market prices reflect the economic health and prosperity of public corporations, its value should relate to the ebb and flow of the underlying business and economic environment that affects those corporations. That environment is known to vary over time in a cyclical manner described by the economic cycle, which tends to move from periods of expansion to contraction and back on a recurring (but not regular) basis.
The economic cycle is commonly described in four stages: expansion; peak; recession; and trough. While these stages can be shown to recur throughout history, their frequency and magnitude are dependent upon a large number of economic variables such as interest rates, employment, trade imbalances, monetary policy, tax policy, etc.
These factors vary quite a bit, causing the cycle to vary extensively as well. Also, since there are so many variables and they can take weeks or months to gather and compile, predicting the precise peaks and troughs of the economic cycle is challenging, even for the best economists.
The stock market has a cycle of its own that is derived from the economic cycle. Known simply as the “Market Cycle”, its four stages are commonly referred to as:
The market cycle is related somewhat to the economic cycle in that investors will anticipate where the economy is going so they can buy or sell accordingly. Therefore, the market cycle leads the economic cycle and since the economic cycle is difficult to predict, so too is the market cycle. Investors should not expect to be able to pinpoint the turns in the economy or the markets.
Studies have shown that a great many investors tend to continue buying during the distribution phase and selling near the end of the mark-down phase. This suggests that a better understanding of the cycles might help to offset the biases people exhibit at the tops and bottoms of the market cycle.
Tip: Cycles can be somewhat easy to describe, but even the best market analysts, technicians, and economists are challenged to call peaks and troughs. It's helpful to understand the cycle, but don't get lulled into the overconfidence that you can predict them.
How Are Market Cycles Formed?
Cycles in the economy are caused by numerous factors. Among them are:
- Fluctuations in the availability of capital
- Interest rates or monetary policy
- Variations in supply and demand
- The introduction or obsolescence of technologies
Companies, financial institutions, the government, and individuals all react to these fluctuations, causing patterns of expansion and contraction that alternate over time.
By its nature, the stock market is forward-looking and tends to anticipate changes in the economy by as much as six months. Thus, the market moves in its own cycle over time, based on where investors believe the economy is going, and investors can be more fickle than the economy. Investor sentiment toward stocks also varies with factors other than the economy, such as the geopolitical climate, technological developments, and pandemics. As a result, neither cycle is regular nor predictable and the market cycle can end up looking completely different from the economic cycle.
Identifying The Phase Of The Market Cycle & What That Means For a Portfolio
To assess the state of the economy at any point in time requires lots of data and the data takes time to collect, measure, and compile. As a result, no one can say with certainty when a particular phase in the economy has ended until after the fact. In addition, changes in some influencing factors can occur in isolation, causing the market to temporarily diverge from the economy. That’s why even the most notable economists are often at a loss to say exactly where the economy is headed at any point in time.
Even without that precision, however, we can generally assess what phase we are in and therefore what phase we are about to move into next. We just don’t know exactly when or how impactful the transition will be. That information alone, though, can be helpful in formulating long-term portfolio strategies.
Note: Trying to assess the economic cycle can affect the nature and timing of investment decisions but should not be taken to imply that it equates to “market timing”. Market timing is a much shorter-term practice that is generally based on factors other than the economy, such as price and volume levels, moving averages, support and resistance points, and other technical factors.
How Long is a Typical Market Cycle?
Market and economic cycles typically last multiple years. Records kept by the National Bureau of Economic Research (NBER) tell us that the average economic cycle since 1854 has been 38.7 months and since 1945 has been 58.4 months.
According to Fidelity, as of November 2021, “the US remains in mid-cycle expansion, underpinned by additional economic reopening, strong consumer balance sheets, and rising corporate profits.” That makes the current expansion the longest-running expansion in history. As of January 2022, the markets could possibly have moved into distribution phase, but that won’t be a certainty for months.
4 Stages of a Market Cycle
A conceptual diagram of the market and economic cycles is shown below.
1. Accumulation Phase
The accumulation phase follows a decline that may have been severe and still carries its residual effects, Early buyers include corporate insiders, value investors) and those who were fortunate enough to raise cash during the decline. In this phase, valuations are attractive relative to historic levels, though skepticism remains and sentiment still leans toward bearishness.
The media still carries stories of the previous decline and many people only recently capitulated, taking losses they could be patient with no longer.
2. Mark-up Phase
The tipping point arrives and people broadly accept that a bottom is in. The market has turned and people are buying in earnest now. Market technicians jump in, bolstered by confirmed uptrends and rising moving averages. Greed and FOMO (fear of missing out) also return. Media stories change to highlight the sectors that have recovered and start projecting new highs once again.
Valuations expand and the logic for it is that "It's different this time." The late folks are piling in and the smart money is happy to sell to them.
3. Distribution Phase
The distribution phase has the early buyers selling to the latecomers as volume is high, but 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.
The final stages of the advance climb a wall of worry as 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
The decline phase is usually already in full swing when people come to realize the top has occurred, but loss aversion will prevent many from selling. Some will try to catch the falling knife for a bargain but will realize the bottom isn’t here yet.
Business Cycles vs. Market Cycles
In theory, stocks should mirror the business and economic cycles as those cycles determine the underlying health of corporations and portend their future prospects. But in reality, the disconnects between the stock market and the economy are more common than the parallels. For one thing, people buy stocks for what they might be worth in the future—usually some months or even years from now. And if investors get spooked by news, they can simply change their minds.
Another culprit is the collective sentiment of investors, which waxes and wanes in only minor harmony with the fundamentals. Good or bad economic news can often lead to a good or bad day for stocks, but the correlations over weeks or months are hardly noticeable anymore.
Understanding the basics of economic and market cycles is important for putting short-term events in context as they might or might not affect the market. The cycles won’t give you short-term trading signals, but they will give you a longer-term perspective that should have a positive impact on your overall investment strategy.
This article was written by
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