Stock Market Cycles
Bull and bear stock market cycles have repeated many times since the beginning of the exchanges. It is highly probable that they will continue to repeat up and down indefinitely, at least until human nature changes. When the emotions of greed, fear, uncertainty, and complacency are eliminated from the human experience, maybe then the markets will take on a different character. The key to trading successfully is knowing where you are in the market cycle.
Although each cycle has its own unique flavor, there are distinguishing characteristics to each of four different phases of the market cycle. The four phases are: market bottoms, bull markets, market tops, and bear markets. Each phase gives unique clues to those who learn how to observe price and volume. Lets begin with the first phase.
Market Bottoms
Phase one for the purposes of this post will be the bottoming process. Although market bottoms vary widely, it is a time when the emotion of fear has been exhausted and down volume dries up. Stocks cease to sell off on bad news. Fear is replaced by complacency and ambivalence as demonstrated by trading ranges and congestion. Markets during this phase typically go through a healing process. Volatility decreases and the average daily price range narrows. Once the moving averages flatten out, trend lines are eventually violated.
SPY 2002-2003 Market Bottom
The 2000-2003 bear market put in a triple bottom as shown above. Notice how the down volume dried up while the up volume increased. Once SPY broke out of it’s trading range, it formed a tight base above the 20 SMA.
Bull Markets
Once the bottoming phase begins to show signs of higher highs and higher lows, the market transitions into a bullish trending phase. Less than expected bad news results in new break outs from trading ranges and congestion. Short term moving averages cross over longer term ones. Volume is greater on up days and drops during retracements. The volatility index remains low. Areas of resistence break while areas of support hold. Earnings reports are becoming increasingly positive. Interest rates begin to rises. The bond markets trend lower. Demand for commodities are on the increase.
2003 Bull Market is Born
The example of the SPY above shows it breaking out of it’s trading range at the end of May. Then it forms an area of tight congestion, above the 20 SMA, for a period of 13 weeks. In the first week of September, prices break out of congestion and put in a second higher high as well as three higher lows. A trend line is beginning to form. The 20 SMA is above the 50 SMA. A new bull market has been born. Buy all retracements and break outs.
Market Tops
The topping phase is marked by increasing volatility. Volume during up days dries up. Down day volume increases and can be steep and swift. Prices can spike up a few more times to new highs and fall precipitously out of exhaustion. Fear and uncertainty is in the air. Companies that barely miss their earnings estimates are punished swiftly. Trend lines are broken and short term moving averages cross under longer term ones. Average daily price range increases dramatically and becomes wild and whippy. Key support levels are broken and lower highs and lower lows are made. Interest rates are still rising and the bond market is showing signs of a bottom.
2007-2008 Market Top
In the example of the 2007-2008 SPY market top above, there were many warning signs leading up to the top itself. The last warning was the steep correction in March on increased volume. The 20 SMA was broken, but prices went on to make two higher highs. In mid August, prices fell precipitously back to that March low, marking a key area of support. The high was made in early October, followed by a lower high in December. In mid January, on increased volume, key support and a long term trend line were violated. The 20 SMA has crossed under the 50 SMA and a lower low is made. In the week of August 11th, SPY has made three lower highs and two lower lows. As it retraces to the 20 SMA it forms a sell set up. The bear market is now in full force. Short all retracements and break downs from congestion.
Bear Markets
Bear markets are typically steeper and shorter lived than bull markets because fear is a stronger emotion than greed. Since prices can move far and fast, it may be difficult to find low risk sell set ups on the daily and weekly charts. This can be remedied by drilling down to the shorter intraday time frames. Down days outnumber up days. Retracements are shallow, short lived, and have light volume. Moving averages cross over on multiple time frames. The volatility index spikes to all time highs. The market no longer responds positively to good news. All stocks are punished with the overall market, regardless of fundamentals. Interest rates begin to fall, due to fear of deflation. Demand for commodities diminishes. Transports and Utilities reflect a weakened economy.
2008-2009 Bear Market
In the example of the 2008-2009 bear market in the SPY, the weekly chart shows only one low risk entry in the week of August 11, 2008. More opportunities to short were found on the daily charts, and many more on the intraday charts. The trend line was redrawn to reflect the steepness of the sell off. That trend line was broken after making a “V” shaped bottom, followed by 11 weeks of consolidation above the 20 SMA. Time to cover all shorts.
More than 50% of the gains made during the bull market can quickly disappear. It behooves us as traders to study stock market cycles so we are better equipped to profit from all four market cycle phases.