Making the most of the market cycle

This has been an eventful year for investment markets as countries locked down to stifle the coronavirus, halting nearly all economic activity and triggering global contractions. Stock markets suffered dramatic falls at the end of March but have since made a good recovery. The question of whether a further crash is yet to come, however, remains. Added to concerns over a second wave of Covid-19 is the political situation in America, in the run up to November’s Presidential Election, which has the potential to drive market volatility far beyond its own shores.

However, some volatility is predictable. In particular, understanding the market cycle can go some way to understanding why markets behave as they do.

Markets have their moments of buoyant optimism and their moments of grim pessimism. These often map to the economic cycle, where there are times when people want to buy cars and houses and take on debt, and times when they face job losses, or would rather retrench, save up and store cash.

Academics have given these market phases names: accumulation, mark-up, distribution and mark-down. While each market cycle will look slightly different, with hindsight, they will often share some common characteristics.

Accumulation

This is the beginning of a market recovery. After a market sell-off, a few smart investors will realise that stocks are cheap and probably won’t go much lower. This can happen even while the news is still bad – headlines may still be signalling the ‘end of equities’, corporate earnings may still be sliding, but a few brave contrarians will be willing to go against the herd.

In this phase, valuations are cheap, but the balance of buyers and sellers is slowly turning. Sentiment slowly switches from negative to neutral and this is enough to push prices gradually higher. However, price rises are generally slow as investors adjust to a new environment.

Mark-up

Once the market has been stable for a while, investors slowly begin to put the last sell-off behind them. Momentum-driven investors may start to realise that the direction of travel has changed. A fear of losing money turns instead to a fear of being left behind in a market rally.

As more people come on board, market volumes start to rise and valuations climb. This is where bubbles can start to pop up: investors may get very excited about a particular on-trend sector – from robotics to biotechnology – and prices climb beyond rational norms. It may be at this point that the early contrarians start to ship out. They may be selling to laggards who have been sitting on the sidelines.

There will often be a crescendo as the cycle nears its peak, known as a ‘selling climax’ when large gains happen in short periods. This may also be concentrated in a handful of fashionable stocks.

Distribution

This is when markets mark time. Valuations are high, but there are still enough investors chasing high returns to support them. This would be a great time to sell, but too often the economic environment looks pretty good, investors have made some cash and would like to make more. It can be a difficult psychological leap to sell when everything appears to be going swimmingly.

Markets can be volatile during this period: investors will have times where they succumb to fear followed by times when they are feeling good about life once again. High valuations leave investors vulnerable because a lot of good news is already priced into the market and disappointments are often dealt with harshly.

Mark-down

This is the painful time for investors still holding on in the hope of gains. They are often triggered by some kind of shock, which may be as significant as a global pandemic or as mundane as an interest rate rise. Investors will often panic-sell at the first sign of trouble, which accelerates falling prices. Equally, market algorithms will often detect a turn in the tide, which can magnify losses. When all those panicking investors have sold – capitulation – then the accumulation phase can begin again.

The problem of course, is that it is not always easy to tell which phase of the market cycle is in progress. Are markets still in their crescendo phase? Or is it simply a short-term rally in the distribution phase? Nevertheless, for the trader who can anticipate these cycles and hold their nerve through each phase, it is possible to capitalise.

The sensible long-term investor will do nothing, recognising that market cycles are inevitable and timing moves in and out is difficult to do well. They will keep collecting their dividends and hold on for the next accumulation phase, which will come eventually. The key is to recognise that markets are cyclical and not to let fear or greed take hold of your investment strategy.

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