How to Read Market Cycles

[avidinuq]

I find it helpful to think in terms of market cycles, rather than trends. A cycle consists of both trending and non-trending components. Understanding where we're at in cycles helps us identify whether we want to be going with strength or weakness or whether we want to fade these. Once we think in cycles, it's silly to identify ourselves as trend traders or counter-trend traders. Our job is to profit from the various phases of market cycles, not try to make market activity fit our predetermined trading preference.

[axehojouojezo]

Market Momentum Bottom - Here is where we wash out on elevated volume, with a maximum number of stocks registering fresh new lows. Volatility is high and correlation is high, as the great majority of stocks and sectors are participating in the decline. An example of a market momentum low was January 20, 2016, when we dropped on high volume with over 2600 stocks across all exchanges registering fresh three-month lows.

[Backlitrnf]

The extreme selling brings in value buyers and we get a sharp bounce from the market lows, followed by further attempts at selling. At major market lows, this bottoming process can occur over a period of weeks or more; at intermediate lows, it may occur over subsequent days. An example of a bottoming process was the bounce into the beginning of February, 2016 followed by a decline to new closing price lows on February 11th. Only 1353 stocks made fresh three-month lows at that time, showing that selling pressure was having difficulty moving the great majority of shares lower.

[Basilbum]

With the inability of sellers to move the majority of stocks lower, value buyers return with a vengeance aided by short-covering and that moves the market steadily higher. Volume and volatility are still high, with the vast majority of stocks lifted off their lows. In this phase, we often look for pullbacks but get none of great magnitude, as momentum enables strength to follow from strength. A good example of a momentum phase was the sharp move of stocks higher from mid-February, 2016 through much of March and early April.

[Beaconwvo]

Here is where higher prices get to the point where the market is no longer attractive to value participants and bulls are relatively loaded up. This results in a drop of volume and relatively low levels of volatility. Correlations move lower as some sectors and stocks continue strong, while others begin to lag. Late in a topping phase, we can see the number of stocks making fresh short-term lows expand, even as the overall market averages are near their highs. A short topping phase occurred from mid-April, 2016 through early June. Over that time, price moved higher, but new three-month highs dropped from 1113 to 818.