Understanding Market and Full Risk Cycles

When dealing with investments, one will often hear about the market cycle—what it means, ideas on how to time investing entry points, the impact it may have on your portfolio and assets, and what investment strategies should be employed to hopefully beat the market. To sufficiently assess a portfolio within the current state of the market at any given time, an investor needs to be able to identify and understand the four different stages the markets tend to experience.

Stage One: Accumulation

Every cycle starts with an accumulation period, in which asset values begin to consolidate after experiencing a significant decline, marking the end of the previous market cycle. Once prices have declined to their lows, investors still perceive the market as bearish and are hesitant to buy. Many have even just severed the last of their holdings in fear of suffering further losses. However, this allows for others to capitalize on the opportunity and acquire holdings at discounted prices. As more investors begin to take advantage of this, market value and perception begins to take a positive turn. (For related reading, see: Surviving Bear Country.)

Stage Two: Mark-up

With the market beginning to see growth in prices and investor interest, the cycle enters the second stage, known as the mark-up phase. Due to the actions of investors (typically institutions) in the accumulation stage who invested in stocks at or near the market lows, the markets start experiencing higher highs and higher lows overall. This in turn indicates to sideline investors that the time to rejoin the market has arrived. The uptrend in market performance encourages confidence among hesitant investors who still view the market as bearish, as they did in the accumulation stage. Witnessing the rising prices of stocks triggers demand from investors (typically retail) who do not want to miss out on the potential growth, resulting in additional market recovery or new highs. (For related reading, see: When Insiders Buy, Should Investors Join Them?)

Stage Three: Distribution

As prices start to lose momentum and form a peak, the distribution phase of the cycle begins. Some investors, seeing that the market is no longer experiencing substantial growth, initiate liquidating their holdings in order to maximize their profits. Other investors, who still see hope for a bull market rally, will pick up these newly available assets, subsequently causing a period of higher volatility as prices fluctuate in either direction. With half of the buyers keeping one foot out the door, prices experience lower highs and lower lows, turning the tide on market sentiment.

Stage Four: Mark-down

The remaining investors holding losses slowly discover once again that what goes up must come down. Realizing that stock values are now suffering from a downtrend, those left in the beat down names begin to feeling greater angst over their holdings and sell their assets, contributing to the further mark-down of prices. Some will still linger, holding on to their investments, leading them either to capitulation (panic selling that builds momentum, causing a dramatic decline in stock prices) or the position of a long-term investor. The depreciating prices begin to bottom out, and investors who got out at the peak of the distribution phase will begin to buy the discounted holdings, restarting the cycle with a new period of accumulation. (For more from this author, see: The 4 Stages of the Investor Emotion Cycle.)

While understanding the market cycle is vital for a well-informed investor, many often don’t learn how to view the market the way they should for optimal investing success—as a full risk cycle. 

A full risk cycle is determined by the movement of the volatility index (VIX). One full cycle is measured beginning with an initial spike in measured volatility, followed by a decline in the index, and then finished off by another jump in volatility. These measures of up-and-down market movement can also be seen through the market trends that are described as "bear" and "bull" periods.

As of May 2017, investors are experiencing the second longest bull market in United States' history. 

Figure 1: S&P 500 Large Cap Index measured from Jan. 2007-May 2017

A Bullish Investment Environment

This historic run marks a period of market performance that is typically viewed optimistically by investors. These defining aspects of a bullish environment cultivate a positive investor attitude and imply a strong or strengthening economy along with rising employment numbers. The term bull market is historically used after a 20% rise in stock prices from the most recent lows. These bullish periods can last years (as the United States is currently experiencing) and is only considered over when there is another 20% decline. This decline marks the end of the bull market and the beginning of a new bear market.

Bear Market

A bear market is characterized by falling stock prices and investor pessimism. While these market trends are historically shorter than bull markets, the bearish periods are often exacerbated by investor anxiety. Falling prices trigger investors’ anxiety, which in turn leads to increasing unease and ultimately selling. This perpetuates the cycle and extends the decline, resulting in a longer bear market.

While bull markets are typically longer, there is no way to gauge how long a market cycle will last. The cycle varies, depending on the particular market or holding you are tracking. One way to understand where the market is at may be measured through the four stages that the cycle will experience before restarting.

Individuals should take the time to educate themselves on the four stages of the market cycle to help them understand the full risk cycle more and hopefully sharpen their investment choices.

(For more from this author, see: An Investment Strategy for Market Volatility.)

For more information on low volatility investment strategies, you can download the whitepaper: Mastering Market Volatility Over a Full Risk Cycle.