A bubble happens when investors place so much demand on an asset that they drive the price beyond any accurate or rational reflection of its actual worth.
Like the soap bubbles a child likes to blow, investing bubbles often appear as though they will rise forever, but since they are not formed from anything substantial, they eventually pop. And when they do, the money that was invested into them dissipates into the wind.
A bubble is barely one in every of many market phases, and to avoid being caught off-guard, it’s essential to grasp what these phases are. An understanding of how markets work and a decent grasp of technical analysis will assist you acknowledge market cycles.
What are Market cycles?
Market cycles are the periods of growth and decline in a market, sector or industry. A cycle usually consists of trends and patterns that emerge during different market or business environments.
During a cycle, some securities or asset classes tend to outperform others because their business models align with conditions for growth.
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In a quantifiable sense, market cycles are visible in price movements that rise, fall, and return to their point of origin. In a soft sense, market cycles are periods of innovation within specific industries.
Phases of a market cycle
Human feeling plays the most important role in market cycles. Through good and bad times, we discover obvious proof of an equivalent capitalist behavior; it has been programmed into our central nervous systems over thousands of years.
The problem is most investors and traders either fail to acknowledge that markets are seasonal or forget to expect a change in a cycle. But an understanding of cycles is essential if you want to maximize investment or trading returns.
Here are the four major components of a market cycle and how you can recognize them.
The accumulation phase begins when institutional investors – such as mutual funds, pension funds and large banks – buy up substantial shares of a given asset.
Price forms a base as the shares of the asset are accumulated. Institutional investors must buy over long periods of time so as not to conspicuously drive up the price of the stock, giving them a long time horizon.
This phase is not a lucrative time for retail investors to buy, as capital will be tied up, or the investor may experience a large drawdown of capital. However, recognizing the signs of accumulation gives insight to future opportunity. During this phase, price moves mostly sideways in a range. The range is identified by variable pivot highs and lows and whipsaw-type price movement as could be seen in the image below.
The accumulation phase often falls into the end of a downtrend where ordinary investors believe that more bearishness is likely and the overall outlook is pessimistic. For the smart money, however, it can be a good point to enter such a market when the price is at a low. At the same time, this does not mean that a trader should try to pick a bottom during a bear market; that’s what makes trading the accumulation phase difficult.
During the markup phase, price breaks out of range and begins a sustained uptrend. An uptrend is defined as a series of higher pivot highs and higher pivot lows.This stage is when price begins moving up. The big money has established a position and retail investors are now invited to join in the profit party. This is the most profitable time to own the stock – an opportunity to let your profits run. The earlier you can recognize this stage, the more you can profit.
Typical Markup phase. Trends are more likely to continue than to reverse, so a trader is expected to ride the trend as long as price remains above the trendline.
Source: TDAmeritrade Strategy Desk
The distribution phase is then the origin and the initial phase of a bear market where sellers begin to dominate. Whereas the informed investors unwound their long positions during the excess phase, they will now enter new short positions during the distribution phase. At this stage, the market tends to be overbought, although the uninformed traders still believe that more bullishness (uptrend) is on its way.
The fourth and final phase in the cycle is the most painful for those who still hold positions. Many hang on because their investment has fallen below what they paid for it, behaving like the pirate who falls overboard clutching a bar of gold, refusing to let go in the vain hope of being rescued.
Prices go lower with no new high in sight.
Source: TDAmeritrade Strategy Desk
Although not always obvious, cycles exist in all markets.
A cycle can last anywhere from a few weeks to a number of years, depending on the market in question and the time horizon at which you are looking. A day trader using five-minute bars may see four or more complete cycles per day while, for a real estate investor, a cycle may last 18-20 years.
For the smart money, the accumulation phase is the time to buy because values have stopped falling and everyone else is still bearish. These types of investors are also called contrarians since they are going against the common market sentiment at the time. These same folks sell as markets enter the final stage of mark-up, which is known as the parabolic or buying climax. This is when values are climbing fastest and sentiment is most bullish, which means the market is getting ready to reverse.
Warren Buffett has a saying about the stock market and investing in general:
Be fearful when others are greedy and greedy when others are fearful.
Disclaimer: This post has been contributed just for educational purposes and should not be regarded as financial advice of any sort.
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