Stocks Cycle Through Four General Phases
Stocks cycle, going through a pattern of advance, consolidation, decline, base-building, and advance again. To buy right and to sell right, it helps to know where a stock is in its general cyclical pattern.
The illustration shows the four general phases through which all stocks cycle. Some technical analysts refer to these “phases” as “stages,” but all stocks cycle through the same general cyclical pattern whatever you call the parts of that pattern. Value Line does not discuss these phases, but The Valuator’s “flag” system breaks the pattern down into 8 phases with a different flag for each phase. For information on The Valuator, go to https://www.stockdisciplines.com/valuator For the sake of this discussion and to simplify, think of the general pattern as similar to what you see if you draw the letter “S” backwards and turn it on its side. More accurately, the general pattern of stock behavior most of the time is similar to a sine wave ∿. The exception is when the stock is trending, but most of the time even a trending stock has a tendency to cycle. To help us visualize a stock’s cycling scenario, let us assume the smooth sine wave in the above illustration represents the moving average of the stock. When the stock is in a rising trend, it will be above its rising moving average most of the time. When it is in a declining trend, it will be below its declining moving average most of the time. The stock’s actual pattern has more of a jagged sawtooth look than that of a smooth sine wave.
The jagged line in the above chart represents the price action of a stock (assume its high is $50 and its low is $25), and the heavy curved line represents its moving average. In the chart above, the stock begins in decline. Eventually, as the price of the stock falls and the fundamentals of the company begin to look better, bargain hunters begin to show some interest. At first, they quibble about price. Then, as the stock declines, new buyers stop holding out for further discounts before buying. Also, many current holders are deciding that they don’t want to sell at such a low price. At this point, the price of the stock stabilizes in a trading range (defined by the two parallel lines) where buying and selling pressures are in balance. The upper boundary represents resistance to higher prices. The lower boundary represents support that keeps the stock from falling to lower prices. We will call this Phase A— Base-building. That is, the stock is building a base from which it can launch its next upward advance. What is actually happening is that new investors with high expectations for the stock are replacing the nervous ones who are looking for an excuse to sell. This process is called “accumulation.” The new holders of the stock will not be shaken out of their positions easily. These “believers” give the support needed for a move to higher levels. They will not sell easily. They just bought the stock because they believed in its profit-generating prospects. To sell quickly would be to admit immediately that they were wrong (and to deny the growth potential for which they just bought the stock) without even giving the stock time to prove that they were right. Most people are reluctant to reverse course like that (at least without waiting awhile and suffering a little). The chart shows only a few cycles in this phase, but the chart is overly simplified. A good “base” will take at least six to eight weeks to develop.
A stock can be in a basing pattern for years. Therefore, it is often wise to wait for a significant breakout above the trading range. This may mean giving up a few points, but the waiting time can be more costly than the extra points if the wait is prolonged. It is therefore better to employ the money in some other way until the breakout actually occurs. When it becomes apparent that the stock is no longer falling, increasing numbers of bargain-hunters begin to buy shares. Eventually, buying pressure lifts the stock until it breaks out above the overhead resistance represented by the upper boundary of its trading range. Because it takes significant buying power to break through this resistance, such an event is considered a very positive event for the stock. Generally, the next stage of a stock’s price action commences when three things are accomplished: the stock breaks out above its trading range, the moving average has begun to climb, and the stock begins to have closing prices above this rising moving average. It might be useful for you to know that our own stockdisciplines.com traders have tested all moving averages from 3 days to 200 days to see if one gives more profitable trading signals than another. The data from the test results convinced us that the best moving average to use for the purpose at hand is the 150-day simple moving average.
After these events occur, the stock begins to zig-zag its way to a higher valuation. We will call this rising trend of the stock Phase B—The advance. The ideal time to buy a stock is early in Phase B (the “sweet spot”). The arrow points to the red trendline, formed by connecting the lows of the stock’s upward move. It takes three or more points to define a significant trendline. If you miss the “sweet spot” but want to buy anyway, do so only after the stock has pulled back to the support of a moving average or trendline. Then, if the support fails to hold, you can sell immediately with little loss. If you buy when a stock is several points above its support, you will lose more if the support fails to hold (you will lose the number of points the stock is above support plus the points you will lose after support breaks down). Place your stop order to sell enough below support so you won’t sell simply because of a random spike.
As the stock reaches higher and higher valuations, increasing numbers of investors begin to take their profits (they sell). Other investors begin to recognize that the stock is having difficulty advancing (because of increased selling), so even more begin to sell. Eventually, as selling and buying pressures come into balance, the stock reaches a state of equilibrium. We will call this Phase C—Topping out. The stock has lost its upward momentum and has begun to move sideways in a trading range. The moving average also loses its upward slope and begins to flatten out. There is a chance the stock will break out on the upside again, but this is uncertain. The greater probability is that it will decline. Therefore, now is a good time to take at least part of your profits (information in The Valuator‘s tables will help you evaluate the situation). If you decide to keep all or part of your position, place a “stop order to sell” just below the new trading range. Then, if the stock breaks down, it will be sold automatically by your broker.
When investors see that the stock cannot make headway after a significant rise, they become nervous. They now have profits and an incentive to sell. As they sell, the stock weakens further and the selling begins to accelerate. The stock then breaks below the bottom of its trading range (its support zone). If you have not sold yet, now is a good time to do so. The moving average begins to slope downward and the stock’s price is below the moving average. We are now in Phase D —The decline. The cycle repeats.