By Chad Langager and Casey Murphy, senior analyst of ChartAdvisor.com
Since the most vital trend to understand is the primary trend, this leads into the third tenet of Dow theory, which states that there are three phases to every primary trend – the accumulation phase (distribution phase), the public participation phase and a panic phase (excess phase).
Let us now take a look at each of the three phases as they apply to both bull and bear markets. During this phase, negative sentiment starts to dissipate as business conditions - marked by earnings growth and strong economic data - improve. As the good news starts to permeate the market, more and more investors move back in, sending prices higher.
Primary Upward Trend (Bull Market)
The Accumulation Phase
The first stage of a bull market is referred to as the accumulation phase, which is the start of the upward trend. This is also considered the point at which informed investors start to enter the market.
The accumulation phase typically comes at the end of a downtrend, when everything is seemingly at its worst. But this is also the time when the price of the market is at its most attractive level because by this point most of the bad news is priced into the market, thereby limiting downside risk and offering attractive valuations.
However, the accumulation phase can be the most difficult one to spot because it comes at the end of a downward move, which could be nothing more than a secondary move in a primary downward trend - instead of being the start of a new uptrend. This phase will also be characterized by persistent market pessimism, with many investors thinking things will only get worse.
From a more technical standpoint, the start of the accumulation phase will be marked by a period of price consolidation in the market. This occurs when the downtrend starts to flatten out, as selling pressure starts to dissipate. The mid-to-latter stages of the accumulation phase will see the price of the market start to move higher. (For related reading, see Consolidation - Trade The Calm, Profit From The Storm.)
Figure 1: the accumulation phase
A new upward trend will be confirmed when the market doesn't move to a consecutively lower low and high.
Public Participation Phase
When informed investors entered the market during the accumulation phase, they did so with the assumption that the worst was over and a recovery lay ahead. As this starts to materialize, the new primary trend moves into what is known as the public participation phase.
This phase tends not only to be the longest lasting, but also the one with the largest price movement. It's also the phase in which most technical and trend traders start to take long positions, as the new upward primary trend has confirmed itself - a sign these participants have waited for.
Figure 2: the public participation phase
The Excess Phase
As the market has made a strong move higher on the improved business conditions and buying by market participants to move starts to age, we begin to move into the excess phase. At this point, the market is hot again for all investors.
The last stage in the upward trend, the excess phase, is the one in which the smart money starts to scale back its positions, selling them off to those now entering the market. At this point, the market is marked by, as Alan Greenspan might say, "irrational exuberance". The perception is that everything is running great and that only good things lie ahead. (For more insight, read How Investors Often Cause The Market's Problems and The Madness Of Crowds.)
This is also usually the time when the last of the buyers start to enter the market - after large gains have been achieved. Like lambs to the slaughter, the late entrants hope that recent returns will continue. Unfortunately for them, they are buying near the top.
During this phase, a lot of attention should be placed on signs of weakness in the trend, such as strengthening downward moves. Also, if the upward moves start to show weakness, it could be another sign that the trend may be near the start of a primary downtrend.
Figure 3: the excess phase
Primary Downward Trend (Bear Market)
The Distribution Phase
The first phase in a bear market is known as the distribution phase, the period in which informed buyers sell (distribute) their positions. This is the opposite of the accumulation phase during a bull market in that the informed buyers are now selling into an overbought market instead of buying in an oversold market.
In this phase, overall sentiment continues to be optimistic, with expectations of higher market levels. It is also the phase in which there is continued buying by the last of the investors in the market, especially those who missed the big move but are hoping for a similar one in the near future.
As was the case in the accumulation phase, the distribution phase can be difficult to spot in its early stages. The reason for this is that it may be disguised as a secondary downward trend within the primary upward trend.
From a technical standpoint, the distribution phase is represented by a topping of the market where the price movement starts to flatten as selling pressure increases . The mid to latter stages of the distribution phase will see prices start to fall as more and more investors, anticipating weakness, exit their positions.
A new downward trend will be confirmed when the previous trend fails to make another consecutive higher high and low.
During this phase, negative sentiment starts to dissipate as business conditions - marked by earnings growth and strong economic data - improve. As the good news starts to permeate the market, more and more investors move back in, sending prices higher.
Dow Theory: Market Indexes Must Confirm Each Other
Public Participation Phase
This phase is similar to the public participation phase found in a primary upward trend in that it lasts the longest and will represent the largest part of the move - in this case downward.
During this phase it is clear that the business conditions in the market are getting worse and the sentiment is becoming more negative as time goes on. The market continues to discount the worsening conditions as selling increases and buying dries up.
This is also the point at which most trend followers and technical traders start to dump their positions and take short positions as the new downward trend has confirmed itself.
The Panic Phase
The last phase of the primary downward market tends to be filled with market panic and can lead to very large sell-offs in a very short period of time. In the panic phase, the market is wrought up with negative sentiment, including weak outlooks on companies, the economy and the overall market.
During this phase you will see many investors selling off their stakes in panic. Usually these participants are the ones that just entered the market during the excess phase of the previous run-up in share price.
But just when things start to look their worst is when the accumulation phase of a primary upward trend will begin and the cycle repeats itself. (For related articles, see Profit From Panic Selling and Panic Selling - Capitulation Or Crash?)
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