Understanding Market Cycles and the Importance of Technical Analysis

(Do take note that this is just a general example of how a market cycle may look like and the exact triggers for each new bull and bear market would differ.)

Perhaps let’s take a look at how a complete market cycle looks like to have a clearer idea. 

During periods when the economy is growing strongly and corporate profits are rising and beating expectations, the news media tends to cover more on the positive economic outlook and earnings. 

This boosts the confidence and optimism of investors and they gradually increase their risk tolerance to buy more stocks. Over time, this turns into greed as some investors chase after the stock prices, thereby driving up the stock market. 

At the same time, capital markets are open and it is easy to make borrowings. Default level is low. 

As the stock market continues to rally, investors’ greed and confidence build up. Some would even boast about their intelligence for the investment profits made. At this point, the majority of the market participants think that it is impossible for the stock market to decline! 

It follows that the risk is at the highest level now due to extreme greed and optimism. However, the majority of the investors think otherwise. Many of them adopt the “it’s different this time” “the market rally will never stop” mentality so instead, they perceive the risk to be low. That’s why they continue to buy by chasing after the prices even though rationally, it is a more appropriate time to call for defensiveness. 

Based on what we witnessed in the stock market over the last couple of years, do you think the stock market will just continue to always only rally up? At this juncture, what we need is just either a deterioration of the economic condition or disappointing corporate profits or increasing default in borrowings to trigger a decline in the stock market.

As the economy eventually slows, corporate profits decline and the level of defaults increases, investors begin to worry about the outlook and shift towards being more risk averse now. The defaults cause capital markets to close which in turn results in more defaults.

Fewer investors are now willing to invest in the stock market and some of them are selling away their existing positions to keep out of the markets. Hence, stock market prices cascade downwards. As stock prices fall, investors’ pessimism and fear of losing more money grow stronger and more investors are rushing to sell. 

News media would also now be reporting mostly on the negative outlook which induces more fear among market participants. Eventually, even investors who have been holding on to their positions capitulate and sell. The stock market cycle is now at its bottom. 

It may seem too pessimistic for any one to stay in the market but in fact, this is the time when we should turn more aggressive by buying stocks of quality businesses at depressed prices. However, due to the psychology and emotions of investors, most of them would do the exact opposite and stay away from the markets.

But remember the market cycle doesn’t just stop here! Eventually as the economy recovers and the credit market reopens, defaults will reduce and investors begin to shift towards risk tolerance and participate in the stock market again and the stock market will rally up. Those who took advantage of the market crash to accumulate stocks would then be able to profit from the rally.