Cycles in equity markets are thought to relate to the general business cycle, but they are different things that can diverge widely at times. Markets can enter into fitful bouts of high volatility with no obvious change in the overall economic condition. Always remember that markets are forward-looking mechanisms, and mere whispers of a coming economic downturn can cause actual market downturns. Investors are inclined to have extremely short memories and to have studied little of history.
All too often, investors proceed as if current conditions are the “new normal” and will last forever. If the history of equity markets teaches us anything, it is that change is coming. The problem is that we can never know where the inflection points are, and we can never know when the new trend will begin. It is oft said on Wall Street that “Bull markets don’t die of old age.” This is true. Periods of high valuations tend to last longer than periods of low valuations.
Describing market cycles is an old pastime for economists and investors. There are many different descriptions with differing numbers of steps. The precise formulation is not as important as understanding that there are phases that markets will go through, and people tend to go crazy during some of them and make bad decisions. The treatment below follows the taxonomy of the legendary technician Richard Wyckoff (a contemporary of Charles Dow).
The Accumulation Phase
At some point near the bottom, some intrepid souls will rightly judge that the worst is over and that the time to buy deeply discounted stocks has come. The most likely candidates to become buyers at a time when the general market sentiment is extremely bearish are the value investors that see good companies with damaged stocks. The bottom forms when for every stalwart that finally capitulates there is a buyer waiting to buy up those abandoned shares at a discount. There is a lot of truth to the saying that “the darkest hour is just before the dawn” when it comes to market bottoms.
The Mark-up Phase
In this phase, the talking heads are discussing whether the worst is over, but there are still plenty of bears. Technical analysts may be buying back in at this point, noting higher highs and higher lows beginning to form. At the height of this phase, more investors start to develop a fear of missing the recovery, and they too begin to buy back into the market. At the end of this phase, the market sentiment turns bullish, and volume picks up as large numbers of investors begin to pile back into equities.
The Distribution Phase
At this stage, sellers begin to take control of the market, and the bearish sentiment of the previous phase becomes mixed. Prices can trade with a range for a long time during this phase, and the market seems to be going nowhere. Valuations tend to be high, and many value investors have taken profits and are sitting on troves of dry powder. (Which describes what Mr. Buffett is doing in the Spring of 2018). Investors have become extremely emotional, and cognitive dissonance is at its peak. They want desperately to take profits and stash them in a safe place, but cannot bring themselves to forgo the upside of the market take another leg higher. Fear and greed are present in a nearly equal measure. The news causes spikes in volatility that seem inconsistent with the import of the events.
The Markdown Phase
In this phase, markets sell off in a big way, and losses can reach 50% or more. Anyone brave enough to stay the course is down in a big way, and often they throw in the towel. When these die-hard bulls capitulate, it is a signal for the most experienced investors to move in. This is when “blood is running in the streets,” and stocks are at their cheapest.