December 31, 2018

What is a Market Cycle and Why is it Important?

What is a Market Cycle and Why is it Important?

While asset prices may appear to move randomly up and down, technical analysis shows that there are distinct repetitive cycles that occur.

These are predominantly driven by the market moves made by large institutional investors, and in order to trade successfully, individual traders should watch these market moves, or market cycles, closely.

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Market cycles are divided into four distinct phases:

  • Expansion / Accumulation
  • Peak / Markup
  • Contraction / Distribution
  • Trough / Markdown

Breaking Down the Market Cycle Phases

As mentioned above, market cycles have four phases, very much like business cycles. These phases include as follows:

  1. Expansion / Accumulation: Expansion occurs as a result of economic growth and leads to a bull market when investors seek to buy. If an economy is well-managed, it can last for years.
  2. Peak / Markup: Buying pressure reaches its highest point and marks the transition to the contraction stage as major investors no longer want to buy highly priced assets.
  3. Contraction / Distribution: The distribution phase of the cycle marks a weakening of the market, starting at a peak and ending at the trough. This is the period that economists call a market recession.
  4. Trough / Markdown: At this point, the market has sunk to its lowest possible point and starts to transition to the expansion phase.

What Are the Drivers of Market Cycles?

There are several reasons for the natural cycles in the financial markets. Chief among them are macroeconomic factors including inflation, interest rates, economic growth rates and unemployment levels.

A drop in interest rates will commonly send markets higher as they are perceived to indicate economic growth. On the other hand, a rise in inflation is often an indicator of an impending rise in interest rates, causing contraction of the market and slowdown of economic growth.

High unemployment levels also foreshadow economic slowdown, with falling unemployment indicating impending growth to investors.

Market sentiment also plays an important part in determining the movement of market cycles. Due to a variety of factors, there may be a boom period where investors scramble to buy specific assets as well as periods where panic takes over the market, causing investors to sell in large quantities.

Market Cycle Examples

Throughout the history of financial trading, there are examples of financial market cycles. For instance, the massive boom in spending and productivity, triggered by the rise of the baby boomer generation, caused markets to rise during the 1990s. In addition, new technologies, such as the Internet, played their part alongside a high level of debt as a result of low interest rates.

When interest rates rose six-fold at the turn of the century, the dot-com bubble burst, this triggered a mini-recession and a bear market. A rise in the market was quickly followed by the 2007 housing bubble and its subsequent market crash. This then led to a brief rally, the asset bubble and high-interest rates, which are currently prevailing in today’s market.

With this in mind, where do you think the market is headed next?

How Market Cycles Influence Asset Valuation

All experienced traders have strategies that they use to take advantage of current price action. Many traders use the Elliott wave principle when making their trades. The Elliott wave principle is a form of technical analysis that is used in order to analyse financial market cycles.

Traders forecast market trends by identifying highs and lows in asset prices, extremes in investor sentiment, and other factors. This wave analysis concept is based on the principles that “every action creates an equal and opposite reaction.”

This means that if an asset’s price moves up or down, it will then be followed by a contrary movement. This price action is divided into trends, which show the main direction of the asset’s price, and corrections, which usually move against this trend.

Final Words

Understanding market cycles is important for traders worldwide because it allows them to earn maximum profits from trading stocks, cryptocurrencies, commodities, and currency markets. This is even more important for traders of derivatives, like CFDs, who look to profit from both positive and negative price actions, which are characteristic of market cycles.

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