Do you remember the “Where’s Waldo” game, where you have to find the Waldo character among a huge crowd of the other people in the picture?

It took some time, but eventually you would find him, hidden in plain sight!

Before buying a stock, you should find where it is within the market cycle

Knowing what phase/stage a potential investment is currently in is critical. It can mean the difference between huge profits, a large loss or simply treading water, going nowhere.

The 4 phases are commonly known by these names:

• Accumulation
• Markup (uptrend)
• Distribution
• Markdown (downtrend)

If you are buying a stock based on fundamental analysis alone, and not looking at a stock chart, you should be prepared for the chance of months, years of holding that stock at a loss or simply stagnating. It pays to look at a chart and at least do some form of technical analysis to see what phase (I like the visualization of the season) the stock is in.

Breaking down the four market cycles

First, let’s get a visualization of a full cycle using a real-world example. This monthly chart of Robert Half International (RHI) shows the four cycles nicely.

You can clearly see the distinct phases…

1. Starting with the accumulation portion in 2012-2013, characterized by an overall sideways movement
2. Followed by a clear uptrend from 2013 until early 2015
3. The distribution phase, from early-mid 2015 to the end of 2015
4. Then the markdown/downtrend through all of 2016.

This is a monthly chart. If you were a long term investor, this would be one of the time-frames you would use. Keep in mind, these phases occur in ALL TIME-FRAMES. You could be a day trader and notice these same four cycles within a particular stock that you trade every single day. You could be a swing trader and have these phases play out over a period of days.

Ok, let’s break down each phase…

Accumulation phase

This phase is clearly the time to buy…agreed? However, very few do. This is because it usually occurs after a previous markdown (downtrend). At this stage, this is when the news articles are usually negative (overall), the FUDders are out in full force.

There are very few retail buyers like you and I

However….

This is when the “smart money” starts entering, averaging into their positions. You might find hedge funds, large institutions and smart retail traders who know value when they see it and are stacking up their positions.

We can agree that it is the good time to buy, but since it doesn’t “feel good”, it is understandable why retail investors and traders don’t take positions. The way to make money is to typically do the opposite of what the crowd is doing. We are herd animals, and taking a position here is lonely and thankless.

However, it is the safest time to enter a position. The previous (typically) downtrend has played itself out. The massive and continuous selling pressure has largely abated and the market is finding an agreeable sideways value area between buyers and sellers. The pressure between buyers and sellers is roughly equal.

The Markup (uptrend) stage

This stage occurs after the stock breaks out of the ranging up and down sideways Accumulation stage. Typically, you will see a large increase in volume that occurs after breaking through the previous resistance of the Accumulation stage.

What causes this jump out of the lazy sideways movement?

Typically there is some type of catalyst that is clearly a bit of good news. Maybe a surprise earnings report, restructuring of debt, a new product, a new client…the reasons are countless.

What matters is that something positive is clearly starting to take place. The volume increase is caused by the good news and by others who were late in taking a position during the accumulation phase are jumping in and taking their positions.

This is when I like to take my positions. I could have been a buyer during the accumulation stage, but I also want to grow my savings as rapidly as possible. That is why I look for signs on the chart for a burst up out of the accumulation phase.

Often, after breaking through the resistance, you will see a retracement roughly back to the top of that resistance point. Up trends start when the bounce occurs at that top resistance point and the stock makes another new high.

As time moves on, the stock makes higher highs and higher lows. Sellers aren’t as prevalent…and when they do sell, they are requiring their shares to be purchased away from them at higher and higher prices. Buyers recognize that they need to pay higher prices to get in on the move and it feeds itself, again and again.

Times are good here, the news articles are glowing, the earnings are fantastic.

Along this ride upwards, this is when the “smart money” that had taken their positions during the Accumulation stage or earlier in the uptrend, unload their positions.

This is the point where the retail investors and traders feel like it is now time to get in. The news has been great, the previous move higher has been great, they start to hear about their friends who have made money and they finally jump blindly in. They are the “dumb money” gladly snapping up shares at drastically marked up prices from the last of the “smart money”.

Often you will see a larger than average move higher, on higher than average volume…sometimes even going parabolic as the buying creates a frenzy (the herd instinct again).

The Distribution Stage

The previous uptrend is showing signs of weakness. No longer do you see higher highs and higher lows. This stage can take place over a short period of time or last weeks or a few months.

One of the hallmarks of this stage is the volume…it is much higher on average than at any point of the previous two stages.

This is because there is persistent sellers as the stock/market tries to rally to a new high. The sellers are now taking control. Also, there aren’t enough new buyers and/or buyers willing to pay ever increasing prices to take a position.

The news is also more mixed. There is more doubt about where things are likely headed.

Here is often where you will see head-and-shoulders patterns, double tops, triple tops…the move can’t seem go any higher on a dip like it had in the uptrend.

This is the last, perfect time to get out, because up next is…

The Markdown (downtrend) stage

Things get ugly here. The stock/market starts to make a new low, often with barely a whimper of an attempted rally back higher. Sellers are coming out in droves.

Sometimes you will see very sharp, massive moves downward, as there is a mad rush for the exits (the herd again…picture everyone trying to rush for the exits at the same time).

There are attempted rallies higher, but they are met by still more selling.

After all, there aren’t that many buyers willing to step in anymore as we had during the uptrend. All of the large, institutional traders and investors are long gone.

Retail investors who bought on the way up, or during the distribution stage, hang on, hoping there will be a rally to get them out at breakeven. Of course, this rarely happens and they ride it still lower.

Over time, more and more sellers start to capitulate, throwing in the towel in disgust with a large loss. This continues to feed on itself, creating more selling by holders who were hanging onto a thread of hope to get out at breakeven.

The news is bad, it’s ugly and there isn’t much good to report.

Over time, this will continue until the selling dries up and we start to enter the beginning of the Accumulation stage again.

A few tips for you related to these stages

Take a look at that chart I posted again of Robert Half International (RHI).

Do you see that 50 day moving average (DMA)? For those unfamiliar with a moving average, it is the average price over the previous 50 days. With each new day, the new closing price is included and the oldest closing price is dropped from the calculation of the average price.

It smooths out the up and down movements of the stock price. You can use this as a good gauge of what phase a stock is in.

Here are some areas to make note of:

• Did the stock just move from below the moving average to above the moving average? (this could be the end of the Accumulation stage)
• Is the stock above the moving average? (This could mean that the stock is in a markup/uptrend stage)
• Is the moving average upward sloping? (Again, this could mean that the stock is in a markup/uptrend stage)
• Did the stock move below the moving average from above? (This could mean that the stock/market has ended the distribution stage and a downtrend has started)
• Is the stock below the moving average? (This could mean the stock is in a markdown/downtrend)
• Is the moving average sloping down? (This could mean the stock is in a markdown/downtrend).

This is a simple way to know what stage a stock or market is in, just by relating the price to a moving average, or where the price is in relation to that moving average.

The duration of the moving average is going to have to be determined by your specific trading timeline. Remember, these 4 stages can occur in a day, a week, a month, or years.

A moving average that a day trader uses would be much shorter in duration than than a swing trader or position trader holding for (days/weeks), and a long term investor’s moving average (days/weeks/months).

Also, relating where a stock is in relation to a moving average is a great way to input into a filtering service.

• Telling the filter to show stocks above/below a moving average is going to show you chart patterns of a certain type.
• Telling the filter to show stocks where one moving average is in relation to ANOTHER moving average is another great way to show chart patterns of a certain type. (if the short term is above the long term moving average, the stock is trending upwards…right?)