Understanding stock market cycles is essential for any investor. Whether you’re a short-term trader or a long-term investor, it’s important to know how stocks move up and down over time.
By recognizing cyclical patterns in the market, you can get better at executing your investing strategy.
The up-and-down nature of markets is so hard to deal with that we often forget that markets have cycles. We get emotional and make decisions that we later regret.
What are market cycles?
Stock market cycles describe the fluctuation in stock prices over time, alternating between periods of growth and decline. Understanding cycles will not make you good at predicting markets.
It will simply help you to make fewer mistakes and avoid losses. As the famous investor Howard Marks says:
“The key to making money is not being right all the time, but minimizing losses when you’re wrong and allowing profits to run when you’re right.”
Marks wrote the best book on cycles, called Mastering The Market Cycle. In the book, he writes about all the different types of cycles that matter to investors, from the economic cycle to government influence.
In this article, I’m only focusing on the cycle in the stock market, which is obviously connected to everything else that’s going on in the world and the economy.
In my experience, having a basic understanding of the cyclical nature of the stock market will give you much more peace and confidence as an investor.
You won’t be able to predict what will happen, but you will be better at explaining why things are happening.
I’ll give you an example of that later. But first, let’s look at the four different phases of the market
The 4 different stages of the market
Market cycles generally exhibit four distinctive phases. This is not an exact science, but this is how investors generally look at the stock market.
- During the Accumulation phase, the market has bottomed and innovators and early adopters are beginning to buy again.
- This is followed by the Mark-up phase when the stock price stabilizes and begins a move higher.
- In the Distribution phase, selling dominates as the stock reaches its peak.
- Finally, in the Downtrend phase, the stock price tumbles down.
Market cycles typically last between 6 to 12 months on average. However, external factors like fiscal policies of major economies and central banks can have a significant influence on the length of a cycle.
For instance, if the US Federal Reserve were to cut interest rates drastically, it could result in a prolonged period of an upward-trending market for several years.
But even in long-term bull markets, there are shorter cycles within certain industries or individual stocks. This is why stock picking is extremely difficult.
You can have a long bull market where the market as a whole goes up, but many stocks might move sideways or even down. That happens all the time. And the opposite happens too.
The market can go down but some stocks might go up. Those stocks that are going up are in a different cycle.
The Covid cycle and subsequent collapse
In March of 2020, stocks started to climb up after the market recorded a bottom because of the Covid scare.
The S&P500 was in an upward trend until December 2021. Then, a clear downtrend started, which we are still in as I’m writing this in April 2023.
Some investors believe we saw the bottom of this cycle in October 2022 at around 3500. The S&P500 is now hovering around 4000 for some time.
No one knows if we will go lower or not. But one thing is sure; we overshot to the upside for nearly two years, and now we might overshoot to the downside.
So understanding cycles are not only about knowing where we are. It’s also about realizing that the next stage of the cycle is often closer than you think.
- Towards the end of 2021, I kept telling myself, “We’re closer to a downward trend than you think.” I realized that the market had been going up in a straight line for a long time and that we were due for a correction.
- I didn’t know when that would happen or how severe it was so I didn’t change my investing strategy. I’m not a short-term trader who places bets in anticipation of market events.
- By the end of 2022, I realized we were closer to a new accumulation phase than I thought. So I kept executing my investing strategy, which was to add to my S&P500 index fund every month.
- I also started adding to a Nasdaq 100 ETF because I realized it was in a downward trend for too long and the companies had strong balance sheets.
The long-term direction of the market is up
Look at the entire history of the S&P 500. This chart clearly shows an upward trend.
Source: Macrotrends
But if you zoom in, you see a lot of ups and downs. This is why investing is so hard.
We get caught up in the current cycle. If we’re in a downward cycle, we all get pessimistic and forget that the long-term direction of the market is up.
When the market is going up, we forget that we’ve had many years in our history that were down. In fact, we’ve had decades where we didn’t make much progress (look at the 2000s or 1970s).
The market is like the seasons. When it’s summer in Europe or in the East Coast, you never know exactly on which day fall comes, but you are 100% sure that it will start to get colder in October. That’s simply the nature of our climate.
In a similar way, you know that a downward cycle will follow after an upward one, and vice versa. It’s not even that important that you know when it happens.
Just the awareness that it will happen makes you much more at ease with markets.
