"The stock market is the story of cycles and human behavior that is responsible for overreactions in both directions" -- Seth Klarman
We all have at some point of time made the mistake of investing at the peak or selling at the bottom of a market cycle. Each loss makes us swear to learn from our errors and avoid getting trapped in future, only to see ourselves committing the same mistakes again. To avoid being tricked by the vicissitudes of the market, it is important to: a) understand the mechanics of markets and its different phases, and b) observe how our emotions fluctuate with different stages of a market cycle. The key to successful investing lies not only in understanding market behavior but also in adapting our temperament and avoiding our psychological frailties.
THE FOUR PHASES OF A MARKET CYCLE
A cycle can be defined as a set of patterns that repeat themselves over a period of time. Similarly, a stock market cycle can be understood as “long-term price patterns of capital markets”. All markets are inherently cyclical- they go up, peak, go down and then bottom out. Each cycle is followed by another in similar fashion over and over again. The length of a market cycle varies from several months to several years. The top of a cycle is referred to as a peak and the bottom as a trough.
Accumulation Phase
It is difficult to refer to anything as the first stage in a market cycle, but for the sake of simplicity, let us refer to the accumulation phase as the first stage. This phase starts after a prolonged downtrend. The market has bottomed out and starts to trade sideways while forming a base. The accumulation phase is characterized by attractive valuations, bearish market sentiment, falling inflation and no clear trend in the underlying market or stocks’ price movement. In the beginning of this phase, market action is typically dominated by investors who entered the market near the peak of the previous cycle. Stung by the market downfall, these players look to make amends by engaging in emotional and reckless trades, which only results in deepening of their losses. Gradually, as they exit the market out of exasperation, it sets the stage for smart money to come. Farsighted investors sense that prospects are due to turn up and start looking for value and building their positions.
Mark - Up Phase
After the relative calm of accumulation phase, the market has consolidated and is looking to move higher as it enters the mark up phase- a period characteristic of underlying market strength. This phase is marked by improving market sentiment, low inflation and improved economic and earnings data. Smart investors tend to buy aggressively here to capitalize on the improving economic conditions. A clear shift in the trend is noticed as market steadily advances and volumes pick up. This is typically the most profitable phase of the market cycle and handsome gains can be made during this period through judicious stock picking. However, the irony is that only a few invest early in this phase and make money as the majority is apprehensive of the rebound in the market. Having burnt their fingers from getting caught at the wrong end of the cycle before, most investors tend to shrug off the bounce back in the economy and wait to invest at secure entry points where perceived risk of market falling is lower. In the process they miss out capturing value and actually subject themselves to the risk of getting whipsawed again.
As the rally grows and cycle matures, herd behavior starts building, thus attracting fence sitters and unprofessional players to start punting in the market. Greed replaces fear, volumes jump, valuations get extreme, inflation picks up and the cycle nears its top. Market sentiment turns from bullish to being outright euphoric during this phase.
Distribution Phase
The mark-up phase leads up to the distribution phase, a period of increasing market volatility. This phase is characterized by dominant selling, ballooning valuations, rising inflation and market sentiment turning from bullish to a more neutral tone. Bereft of any direction, stock prices move sideways and can stay locked in a trading range for a few weeks or even months. This is a very confusing time for investors—hope and greed takes a toll as market often appears to be taking off but only to crash after some time.
Mark - Down Phase
This is the final phase of the market cycle and is marked by falling prices. Sentiment is gloomy as the market tries to find its bottom. This is the most painful period for investors, especially for the late entrants who after being beguiled by the temptation of previous up-moves continue to hold their positions during the fall. Any hope of revival turns into anguish as stock prices continue their downward spiral and cause many investors to exit in panic. This is also the trickiest period in the market and separates the men from boys. While the prudent investors look to spot value and enter at bargain prices, the novice investors lose their nerve and sell out of despair, often at the bottom. Over a period of time, this phase turns into accumulation phase and the cycle repeats itself.
The Cycle of Market Emotions
Human emotion drives financial markets as much or more than market fundamentals. Invariably, we buy out of greed and sell out of fear. Efficient markets are based on the assumption that people tend to take decisions rationally with the intent of maximizing gains. While this is theoretically convenient, in practice it is noted that emotions cloud our rational thinking. Emotional biases are inherent to human decision making and thus it is important to understand our range of emotions and how it affects our interaction with the market. Following is the common market psychology cycle that shows how emotions evolve and change through different stages and may affect our rational decision making:
Do you find yourself at any stage in this chart?
Swayed by our emotions, we often make the wrong decision at the wrong time. Numerous studies have been carried out that clearly demonstrate that individual investors, on average, tend to buy near market highs and sell near lows. Such irrational behavior is a validation of our emotions triumphing rational thought process. Building and holding on to an altered view of reality to suit our biases is comforting for the mind but ill-suited for investment decision making. Many times investors are stuck with positions they could have parted with at a small loss. But the emotional pain of recognizing the loss and the resultant discomfort is too agonizing for most people to accept, thus causing them to make decisions inimical for their financial health.
According to the legendary Warren Buffet, “the most important quality for an investor is temperament, not intellect”. Only when you combine sound intellect with emotional discipline do you get rational behavior, and hence superior investment results.
SUMMARY
Cycles exist in all markets. Smart Investors understand the pattern of market cycles as well as human emotions. They buy when fear is highest, sentiment is bearish, outlook is dim but the valuations are most attractive. Typically, this is the accumulation phase. While these same prudent investors tend to sell when the cycle enters its last stage- typically late mark-up phase and early distribution phase when sentiment is euphoric, outlook is brightest and the valuations are extreme. The key to successful investing is to look beyond economic data and accounting equations. To maximize profits, we need to understand market cycles as well as our emotions, which are often at odds with reality. Happy Investing!