Four Stages of the Stock Market 2 1690

To be successful every trader should learn to understand and identify, in what stage the trending is. Two of the four stages are relatively easy to identify, and the first and the fourth are the most difficult to spot as they are the blending of the bull and bear cycles. These four stages are repeated over and over again.

Any stocks, it has to be in one of the four stages and it applies to all time

  1. Pessimism
  2. Optimism
  3. Euphoria
  4. Fear
Nifty levels

Let’s see how it relates to our trading strategy, what each participant is doing at each stage, what to look for a chart and what the fundamentals are showing.

  1. Pessimism

Most of the investors who were in desperate need to sell have already done by losing the confidence at this stage and reluctant to invest in the stock market. This is a period when nobody wants to invest. So this stage comes after the Bull Run has ended. The public will not be back into the stocks until they reach higher prices. But this bargain prices marks this period as a period of accumulation by Institutions, lending money managers, professionals and value buyers. They may buy it for

  • Good fundamentals
  • Solid business strategy
  • Strong competitive positions
  • Improving earnings
  • Offer real potential for price appreciation
  • P/E ratio of the indexes are low
  • Good return on equity values

How to identify if it is in this stage?

  • When the stock stops hitting bottom price and starts moving to stage 2
  • It begins to break out of their sideways patterns
  • Isolated weekly and monthly highs occur as prices begin crossing their 100-day moving averages.
  • Low volatility

The price as the determining factor that indicates the end of the bear market and it is in the opening stage of the bull market.

“The whole secret to winning big in the stock market is not to be right all the time, but to lose the least amount possible when you’re wrong.”
– William J. O’Neil

  1. Optimism

With the market beginning to see potential for returns and investors begin to invest again as they regain confidence in the markets. It has been stable for a while and starts to climb up due to the actions of investors (mainly institutions) in the accumulation stage. It is the right time to buy the dips and ride the rallies higher; the uptrend in the market encourages the investors who do not want to miss out this potential growth resulting in additional market recovery or new highs. During this stage there will be some pull backs and corrections and it’s just normal for the market to take two steps in advance and one step back as it tries to advance with fewest people.

Accumulation is forcing for higher prices with reduced supply. Rallies are the results of a series of higher highs. Now, the market leaders are taking to the top and mutual fund inflows are increasing as a result of rallies. But still the larger public doesn’t join in the party keeping in mind that bull cycles take times to develop.

How to identify if it is in this stage?

  • Strong volume
  • A pause or pullbacks on a lighter volume
  • Breakouts above 150/200 day SMA
  • Long lap up on the breakout day

So, money is made after the correction, keep the stocks in watch list by doing your home work and own research. The best time to board on is the first pullback or pause after the breakout of the stage 1 and if it’s coming out of a correction, there could be a start of a long trend and it’s the right time to buy.

  1. Euphoria

At this stage, as the price hit their new highs, novice or inexperienced investors jump into the stock market believing that prices might go even higher. While some investors starts distributing their shares through selling, distribution is when the institutions that bought during stage 1 or early stage 2 are unloading their positions. Rest holds hoping it for the uptrend. Smart investors are ready to exit the stock.

How to identify if it is in this stage?

  • Stock loses momentum
  • starts to trade sideways
  • Price may oscillate above and below the 150/200 day SMA
  • Increase in volatility

Late stages are riskier so better take ½ profits at this point, but it could be just a pause before the next move up. During this period, prices will reach their highs, few investors hoping for a bull market rally to continue and feels comfortable investing in additional assets causing a period of higher volatility as prices fluctuate in either direction. So this is the right time to exit the stock.

  1. Fear

At the early stage, nobody believes this is the downtrend and they believe it’s just a correction and it will move up. Smart investors mostly have taken out their profits causing the prices to drop. As the decline continues, investors develop into panic/fear. Fear factors such as energy supply and prices, geopolitical risks, economic performance and emerging market environments all play a role in the daily fluctuation of market volatility. The investors holding losses slowly discover once again that what goes up must come down. Novice investors who are reluctant to sell have to book losses or turn to long term investor or begin to buy at the bottom out price restarting with a new period of accumulation.

During this time of higher volatility it increases the risk in your portfolio.  Any short term predictions at this higher volatility often leads to mistakes results in losses, making it really impossible to guess which way the market will trade.

How to identify if it is in this stage?

  • Lower lows and lower highs
  • Volume higher on the down days and lighter in the up days
  • Breaks below 150/200 day
  • Moving averages turn down
  • Stock or Market has broke down

Sometimes, late stage can work out and lead to gain but it involves more risk, quickly cut your losses when it breakout and fails to gain traction. If it breaks down with heavy volume and pulls back on light volume, it could be a shorting opportunity.

Every investors should be prepared for the unexpected and hold a diversified portfolio. Many makes it complicated and get lost. So all you need is to follow certain methods and discipline. By understanding the each stage of the market, they would be able to understand their investment strategy and make better decision when it comes to their portfolio.

Stay tuned to our next post “Stock Investing and Psychology”

Follow us on Instagram: https://www.instagram.com/rollnreel/

2 Comments

Leave a Reply

Your email address will not be published. Required fields are marked *

The 5/25 and 80/20 rule 0 43

Warren Buffett as we all know him not only thinks about securities all the time but also spends some valuable time making the world a better place and life easier.

His 5/25 rule originates from an anecdote from one of Warren Buffett’s employees. The story goes like this…

Warren Buffett one day approaches his pilot, after realizing that he had worked for him for the past 10 years. Buffett wanted to discuss his pilot’s career goals and wanted to help him achieve them. “The fact that you’re still working for me, tells me I’m not doing my job” said Buffett. To map out the pilot’s goals, he was asked to conduct a simple exercise by Buffett, it would later go on to change the way he viewed his priorities forever…

The first thing in the exercise was to list out 25 things that the pilot wanted to achieve in the foreseeable future. Secondly he had to arrange them in the order of importance (descending) and circle the top 5. During the exercise, he found out that prioritising his goals were undoubtedly more challenging than listing them. Buffett later asks his pilot :

What are you going to do with the remaining 20 items?

The pilot replies with :

Well the top 5 are my primary focus, but the other 20 come in at a close second.

He goes on…

They are still important so I’ll work on those intermittently as I see fit, as I’m getting through my top 5. They are not as urgent but I still plan to give them dedicated effort.

At this point Buffet’s expression changes a little and responds sternly :

No, you’ve got it wrong. Everything you didn’t circle just became your ‘avoid at all cost’ list. No matter what, these things get no attention from you until you’ve succeeded with your top 5.

Avoid at all cost!? His pilot certainly wasn’t expecting that.

Buffett’s 5/25 rule states the importance of selective focus. There’s more competition for our attention than ever. Choices have never been more abundant than any other time in history and it’s unlikely we’ll be constrained any time soon. In fact, our options are likely only going to expand as we advance further. More the people, more the diversification among them, more the desires, therefore resulting in more choices.

It’s the primary reason why most of us will never reach the level of competency needed to reap the rewards of being a superstar like Warren Buffett himself. Each time we pursue a new course of action, we incur an opportunity cost. It takes our time and attention away from the things that are most important to us. Your odds of success improve when you direct your focus into a singular pursuit. You have to double down on a few things and rack up the hours trying to get really good at that. The 5/25 rule is another example of how simplicity makes life better and easier. Warren Buffett doesn’t mean to say that you have to lead a boring life doing the same thing over and over again. Once you have mastered the 5 circled goals, move on to number 6 and beyond but mastering your tasks could take years and needs all the effort and concentration, because we spend time on these only during our free time and we all have other commitments which are out of our control.

If all of us were asked to do the same exercise as his pilot was, most of us would struggle. The result is that we have a list of items that will almost never get completed. This list only weighs on our mind, and fills us with stress, guilt and overwhelm. It’s a result of the ‘any benefit’ mindset. If you observe carefully, you would realize that you put some things on your list of 25 only because you believe you’re going to benefit something from learning or mastering it and not actually because you want to do it. It is that feeling where you believe you can do a lot more things at once than you actually can concentrate on and feel like “If I learnt how to play a guitar, I could participate on stage events and become popular”, when that’s not what you actually want to do. You add those extra goals in that list of 25 only because you feel a dopamine hit.

Pareto’s principle, popularly known as the 80/20 rule tells us that the majority of outcomes are driven by a small number of things that we do. Chances are that anything that falls outside your top 5 will have little impact on your life. Rather than add on, take the time to eliminate.

Time and attention are two of the most finite resources. There will always be more good opportunities than we realistically have time for. We shouldn’t pounce on every one of them, because not all will be right for us. It doesn’t matter how good an opportunity is if all it does is advance goal number 25 for us. If we force ourselves to eliminate options, we would find that only a few things truely matter to us. We would be better served if we ignore distractions and do more of what really matters.

Use the ‘Pomodoro technique’ to shut down all external distractions. The pomodoro technique involves concentrating for a short time span separated by shorter breaks. Break down your work intervals into 25 minutes separated by a 5 minute break and after every 4 sessions, take a longer break. Ideally 10–12 sessions a day could help you master almost anything within 6 months – 1 year.

Another place where most of us fail is during the dip in the transition cycle

When we experience the opportunity to learn something new, we enter into what’s called the ‘Honeymoon phase’. This is where we experience releases of dopamine as we experience new things, we’re hardwired to appreciate and seek out novelty because it makes us feel good. Once the ‘Honeymoon phase’ is over we experience the dip and our progress begins to plateau or diminish and this is when most of us quit. If you can predict the dip is coming when you’re learning something new it’s easier to fight through it because you know the dip exists and it only lasts temporarily.

Vilfredo Pareto, an Italian economist found that 80% of the land in Italy was owned by 20% of the population. This 80/20 distribution became popular for occurring over and over again in many scenarios. For example, about 20% of the world’s population control about 80% of the world’s income. The 80/20 rule by Pareto is the same as Buffett’s 5/25 rule (5 is 20% of 25). You could infact verify it with your own daily life events, you would approximately wear only 20% of the clothes in your wardrobe 80% of the time, if you were to have 5 shoes, you would wear only 1 of them 80% of the time. About 20% of a business’s clients account for 80% of their revenue. This might not always be the case though (but it predominantly is), that being said one can use this to analyze your life and optimize it. For an example, if you have an exam tomorrow but decide to start only the night before. Say you have 10 topics for the exam, pick the 2 topics that would maximize your result, meaning spend time on learning that 20% of your syllabus to earn 80% of the marks. You can use the remaining time, if you have any, to learn the remaining 80% of the syllabus that would fetch you only 20% of the marks, you at least get the important things out of the way and have managed to maximize your result in a minimum time frame.

The Pareto’s principle gave rise to one of my most personal favorite papers to have ever been published. It refers to the phenomenon as ‘The champagne glass effect’.

The paper goes on to explain with deep picturization on how the champagne glass represents the 80/20 rule and how the bowl on top represents the top 20% of the people who have a part of 80% and the rest 80% of the glass, the stem supporting the bowl’s weight with less than 20% of it’s entire weight.

Hope the answer helped you and gave you an insight. Peace 🙂

 

Send this to a friend