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Market cycles: phases, stages, and common characteristics

Source: Bloomberg
  • Market cycles: what you need to know

A market cycle is the process in which bull markets mature from beginning to end and then reverse into a bear market where excesses from the bull market are corrected. These cycles have been unfolding in comparable fashion since market speculation began. While no two market cycles have ever looked identical or had the exact same underlying drivers, they generally exhibited similar characteristics during each portion of the cycle primarily due to human nature and market psychology.

A majority run their course and fall in the ‘normal’ bull & bear market cycle category while some have morphed into full-blown bubbles or manias which resulted in crashes. The difference between the two is the magnitude at which the underlying asset price climbs and the pitch at which investor sentiment rises. In any event, the following will help provide a guide for those who want to learn about the differing phases of a market cycle to help better navigate them.

A market cycle has five main phases: Discovery, Momentum, Blow-off, Transition, and Deflation. A full market cycle may last only a few years or a couple of decades, depending on whether it is a cyclical (short-term) or secular (long-term) trend. Typically, shorter, cyclical trends also develop within the context of the longer, secular trends.

  • Bull market

Source: DailyFX
  • Discovery phase

This phase marks the beginning of an emerging bull market trend and goesunnoticed by the majority of market participants. It’s during this period when the last bear market officially ends and the new bull market begins, however; this doesn’t become apparent until later in the cycle.

Stages & Characteristics:

  • *Duration – Accounts for roughly 25% of the cycle.
  • Accumulation – Smart money investors sniff out an emerging trend and accumulate in anticipation of a new bull market.
  • Trend emergence – Marked by a gradual bullish price sequence of higher highs and higher lows.
  • Shake-out – The initial rally becomes exhausted and the ensuing decline creates enough doubt that it shakes out the weaker hands.
  • Momentum phase

In this phase the trend draws in an increasingly larger market participation base as awareness spreads. Growing participation and excitement builds, accelerating the trend and creating strong momentum.

Stages & Characteristics:

  • *Duration – Typically the longest segment of the bull cycle, roughly 35% of the cycle.
  • Momentum builds – During this phase the underlying bull market becomes apparent to a broader group of market participants. Sentiment feeds a healthy trend.
  • Early on in this phase investors are still largely made up of only sophisticated investors, but as the trend matures an increasingly less-informed crowd joins the trend.
  • First sentiment extreme – Attitude towards the market is healthy and able to sustain a strong trend, and sentiment doesn’t become moderately extreme until the end of the phase.
  • Bear trap – Concerns regarding overvaluation and an ending cycle feed a correction. However, the dip ends with a new round of buyers and provides a base for the next leg of the cycle.
  • Blow-off phase

This is the most violent phase of the bull market as it speeds ahead with maximum participation with the least informed (every day investors) joining in. Market participants’ behavior becomes increasingly irrational, and in the case of bubbles/manias it becomes highly irrational. Eventually the trend becomes unsustainable and typically in an abrupt fashion.

Stages & Characteristics:

  • *Duration – Roughly the final 10% of the bullish portion of the cycle.
  • Renewed optimism – Market participants rebuild confidence following the last correction leading to new highs in the cycle. This reinforces bullish market psychology and the notion that the trend is sustainable, indefinitely.
  • FOMO – ‘Fear of Missing Out’ sets in as the trend accelerates. During this period the least-informed market participants (i.e. – John Q. Public) join in and daily media coverage becomes widespread.
  • Euphoria – At this point, many market participants believe the old rules of market cycles no longer apply and that indeed – “it’s different this time” – prices will rise indefinitely.
  • The most violent segment of the blow-off phase as investor rationality goes out the window – “to infinity and beyond”. Price can even double or more in extreme cases in a very short period of time.
  • ‘Smart Money’ exits – Many smart money managers exit throughout this cycle, but even as such, many sophisticated hedge fund managers are still found guilty of chasing performance.
  • Bear market

Source: DailyFX
  • Transition phase

This is where a major turning point takes shape in market psychology, as the cycle shifts from bullish to neutral to bearish. There is still optimism that the market will continue to trader higher, but enough skepticism at this juncture to prevent it from doing such. In short, it’s a push-pull process between buyers and sellers.

Stages & Characteristics:

  • *Duration – Lasts a small percentage of the total cycle, roughly 5% of the process
  • Shot across the bow – This is the first major decline following the blow-off phase. It serves as a warning shot, marked by a fast and furious sell-off. This breaks the ‘animal spirits’ of the bull market as collectively market participants begin to become less certain about the future.
  • Bull-trap – The rally following the first decline off the high stabilizes market sentiment for the time-being, giving investors a false sense of confidence that the sell-off was nothing more than a sharp, but healthy correction.
  • The Lower-high – Buying pressure fades as skepticism leads to selling. The market begins to behave differently than it had after prior corrections by stalling and creating a major lower-high.
  • Major turning point in market psychology. There is remaining optimism that the market will continue higher, but enough skepticism that this juncture to prevent it from doing such.
  • Breakdown – Confirmation of a top starts here when the prior low from the ‘shot across the bow’ is broken. This morphs into the most damaging portion of the cycle as a large reversal of fortune begins to pick up momentum…

  • Deflation phase

This is really nothing more than the market moving into reverse, or a bear market, and typically unfolds quickly, purging excesses built up during the bull market.

Stages & Characteristics:

  • *Duration – Roughly 25% of total cycle, but can vary greatly as the end of the cycle can last years
  • The purging of excesses built up during the bullish market phases.
  • Fear and capitulation – In this stage, crowd psychology clearly changes as market participants recognize that the bull market is over. As losses continue to mount sellers show up in earnest, driving prices down at a rapid pace. This often leads to panic-selling and capitulation.
  • Bottom fishing – After significant damage investors seeking value look for a bottom but rallies quickly fail. The battle between value buyers and residual sellers (booking losses) keeps the market bouncing along to lower and lower prices.
  • Despair, end of bear – Disgust reigns supreme as losses reach a maximum. Residual selling dries up. Market participants play the blame game here, looking for the culprit. This period can be over relatively short or last several years before leading to a new ‘Discovery’ phase.

*Durations can vary greatly, only rough estimates.

This information has been prepared by IG, a trading name of IG Australia Pty Ltd. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.

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