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There are four phases to a market or indeed a stock cycle: a bottom, an up trend, a top and a down trend. Once one cycle completes another starts in a continuous process. Starting at the low of a cycle, following a period a general decline the perceived backdrop will be almost exclusively bearish with constant negative news flow, yet the market itself will be showing signs of possibly bottoming as capitulation selling is matched by canny buyers who perceive prices have reached bargain levels. At this point covert accumulation is occurring, an essential requirement for the next phase.

The market stabilises and commences on an up trend as more players move to the buying side. At this point technical analysis should pick up the ending of the preceding down trend as minor highs and lows move from a descending sequence to a rising one and trend lines and moving averages are broken above. Buying gathers pace and prices are marked up, new bull trend lines can be drawn and the chart looks positive. Greed kicks in and though valuations are becoming stretched, buying persists as the ‘herd’ instinct develops. The smarter players begin to lighten their holdings and this can result in a slight lull yet even this is often seen as a buying opportunity usually by ‘retail’ and the final and most dramatically sharp leg of the up trend occurs – the buying climax.

When all the frenzied buying has been exhausted a vacuum results and the market enters into a distribution phase as sentiment becomes mixed as to the future course of prices. The bears begin to get the upper hand, sometimes aided by an unexpected and negative macro-economic event that appears to arrive initially unnoticed. Bull trend lines break down and those who follow charts turn negative.

The sell-off gathers pace, yet initially the advice and the desire of many is not to sell but to hang on for a recovery, sentiment aided by a reticence to accept a loss. The market continues down and a significant retracement of the preceding up move is achieved. Finally those who have doggedly held on start to capitulate and sell. In doing so they generate a selling climax which will lead to a new cycle as more successful and astute players begin to buy into the distressed selling.

Clearly the best strategy is to buy during the accumulation phase and to sell during the distribution period. Using technical analysis can aid in capturing the lion’s share of these moves. These buying and selling opportunities can often be isolated by a combination a breakouts as discussed last week, together with observance of breaking trend lines, moving averages and divergent momentum, which is after all the measure of the strength of a trend.