We will now discuss market cycles, which are important for all investors to understand. The two major types of market cycles are:
- Bull markets, where prices rise over a long period of time;
- Bear markets, where prices fall over a long period of time;
A market cycle is a full economic cycle of growth, market peaks, capitulation and eventually price recovery. These market cycles happen over and over again and depend a lot upon investor psychology, monetary policies and corporate earnings.
Market cycles occur in all different asset classes. You will notice everywhere that markets do not move in straight lines.
Investor psychology says that millions of investors together can build so-called “castles in the sky”, which are such extremely high prices that they are simply unsustainable. What happens next is that these man-made “castles in the sky” very quickly drop in price in search of more sustainable levels.
The very basics of investing are that for every buyer there must be a seller, and for every seller there must be a buyer. If prices rise too high, there are simply not enough buyers left.
The four primary phases of market cycles are:
- Accumulation, where smart money begins buying assets after a downturn;
- Markup, where prices begin to rise quickly driven by increasing demand;
- Distribution, where early investors begin to sell their positions;
- Markdown, where prices begin to fall quickly driven by increasing selling;
Major emotions in the stock markets are for example optimism, fear, greed and panic. These different emotions all influence markets.
The accumulation (smart money) phase is the best stage to start buying into assets and offers the best long-term investment opportunities. You can read this on almost any price chart available in the internet.
One example price chart that we like to refer to is the one illustrated below. This chart perfectly displays all different phases of a complete market cycle. There a many examples of charts like these.
As you can clearly see in the price chart displayed above, all assets must eventually return to the mean. This is also an extremely important concept in investing to understand.
In the previous chapter we have discussed Moving Averages. The 200-day Simple Moving Average is a key indicator in long-term investing.
One theory is to get out of an asset that falls below the 200-day Moving Average. Chances are high that this signals a significant trend reversal and that the price is going to fall over a longer period of time. You could see this the other way around as well, and start studying assets that cross above the 200-day Moving Average.
As we have said a little earlier, Central Bank interest rate policies also influence market cycles. Low interest rates encourage more borrowing and therefore increase investments. High interest rates result in less borrowing and therefore slow economic growth.
The most important insight about market cycles is that they are inevitable but unpredictable in timing.
Economic growth, investor behavior and financial conditions naturally produce periods of expansion and contraction.
You cannot perfectly predict market cycles, but you should at least understand them and recognize different patterns. This way you can better navigate the constantly changing financial markets!