At Eclipse Financial Planning we focus on long-term investing to support clients through their financial lives. Over the long-term, we often mention the potential loss in a bad year which will happen from time to time. Here, we breakdown the pattern of a typical market cycle that leads up to these events. This cycle can be best represented with the below chart:
There are four phases to a typical market cycle which are often present in both the wider market as a whole and for individual shares. Understanding each phase, and what it looks like helps us identify when certain clients and their financial plans may be at risk:
Stealth Phase
This is the slow accumulation of money into a market or security, often whilst others are still selling, or before many investors or mainstream funds get involved. Investors at this stage are those that are willing to take a higher degree of risk or uncertainty to maximise returns. They may have a greater understanding of a particular investment or operate a niche strategy of specifically looking out for turnaround companies for example or specially hunting for buying opportunities on dips.
Awareness Phase
Once the ‘smart money’ – those with unique insights and advantages to move quickly – are invested and there are reduced sellers, prices start to move. As speculation becomes confirmation, larger institutional and professional investors like investment funds and pension funds start to invest. It’s easier for these investors to feel comfortable investing a little later and reducing a lot of the risk of being wrong. When they do they have and can therefore invest more money. Some of the early investors from the stealth phase may sell creating a small bear trap giving the illusion the top has been found.
Mania Phase
When a security or the markets investment potential becomes more mainstream the wider public start to invest. This is usually longer in time and can go on for many years. Media coverage will be more evident word of mouth through, friends, family and increasingly social media will entice more novice investors to invest. This helps lift share prices further creating confirmation bias and encouraging people to invest more.
There is a period in the mania phase where the ‘good idea’ comes second to the increase in price, and this is where greed starts to set in. From this point, price rises quicker than in any other phase with investment discipline disappearing. As early ‘nay sayers’ continue to be proven wrong the belief of a ‘new paradigm’ sets in. It is at this time that the last of the early adopters and most of the institutional and professional investors realise the valuations are unjustified and sell.
Blow Off Phase
What is left are the general public holding investments for no other reason that they went up, with no longer any credible reason to hold. As prices stop rising with no new funds being invested and large institutional investors selling, enthusiasm falls, quickly and prices drop. Many will be in denial, hoping to see more of what they saw in the past, often a brief recovery or bull trap is seen through the changing imbalance between buyers and sellers, this can often be produced by the last of the institutional investors reducing their holdings. What’s left is the fear and crash phase this can continue for a very long time until the ‘smart money’ and other institutional investors who understand the value of a business, feel comfortable that the price is attractive once more.
Understanding wider market sentiment can be helpful in managing risk and is often why many successful managers adopt a contrarian approach to investing. When assessing the market and compiling communications from our partner investment providers, we use our anecdotal observations to estimate what stage of the cycle we might be in at any one time.