The cyclic nature of financial markets has been historically-proven over decades: Dutch Tulip bubble, Dotcom bubble, Housing bubble of 2007–2008, Cryptocurrency market crash in 2018, and many more. Although market bubbles are driven by unique forces and vary in many aspects, they are integral parts, or phases, of the market cycle that repeats again and again. Unfortunately, each time plenty of traders and investors suffer huge losses during crises. Thus, it seems that people don’t learn from history? Yes and no.
The idea is that the markets are mostly driven by powerful institutional players that are also sometimes called ‘whales’. They have considerable control over the market that enables them to significantly influence price dynamics. The rest of the market is influenced simply by emotions of retail traders and investors, their systematic errors, and irrational decision-making rooted in cognitive biases. In other words, traders either fail to recognize the market phase, or do not manage to control emotions, being driven by fear and greed.
Although bubbles are inevitable in the markets, you are more likely to survive the crisis and maximize your profits if you are aware of the market phases and their driving powers. So, let’s explore one of the theories related to the market cycle, known as Charles Dow Theory. It will help traders understand the driving forces of the market and make more informed trading decisions.
According to Dow Theory, the market follows four major phases: accumulation, public participation, excess, and distribution. Below there is an illustration of four market phases presented on the Bitcoin chart:
Let us consider each market phase in detail.
The Accumulation Phase: Despair, apathy, boredom
Being the first stage of a new market cycle, the accumulation phase often falls into the end of a bearish trend (the end of the previous cycle). Therefore, the majority of traders and investors tend to believe that either the downwards trend still continues, or the market got stuck sideways (like it was in case of Bitcoin mostly spread among early adopters). The overall market sentiment can be described as neutral or even bored.
However, ‘whales’ are already entering the market, being invisible for most ordinary traders. At the same time, even though the accumulation phase is usually accompanied by slow price movements and a ‘sleepy’ market, it can be recognized. Among the potential signs of accumulation are divergences on technical indicators (momentum, trend-following, volume), inverse patterns, extended price consolidation periods.
For instance, on the chart below you can note a slight divergence Moving averages (MA) for 50 and 100 days in early 2017 with MA 50 above MA 100. It is one of the signs of bull rally formation.
The Public Participation Phase: Impatience, excitement, greed
Since the accumulation phase is over, the next stage — the public participation — is already becoming visible for the vast majority of market participants. The price is starting to increase and overall market sentiment switches to positive. At this stage more and more traders determine an upcoming trend and start getting on the bandwagon, pushing the prices higher. Then the media comes into play with the loud announcements on the market recovery and promising future of the asset. The ‘crowd’ enjoys following the trend and anticipating more profits. Impatience, excitement, and greed drive the market at this stage. Meanwhile, ‘whales’ are still in-game.
The Excess Phase: euphoria, irrational optimism, overconfidence
With further price growth, euphoria and irrational optimism take the market players over. Many of them enlarge or overhold their positions, expecting the price to trend upwards. However, the market is already overestimated (this is where a bubble is formed) that means the bull rally is up to finish.
It is exactly the moment when the ‘whales’ silently leave the fragile market, grabbing the profits amid the rejoicing ‘crowd’. That is why it is important to keep in control of your emotions and timely recognize the Excess phase to quit the market with full pockets. The typical signs of extreme volatility and more sharp pullbacks that swiftly result in a weakening bull rally and a start of the next phase.
On the chart below Relative strength index exceeds 70 (December 2017), meaning that the market is overbought, or overestimated, therefore, the price may be primed for a bearish rally (note that the technical indicators are recommended to be used as additional signals in a complex trading system to get a comprehensive view of the market dynamics).
The Distribution Phase: panic, denial, fear
The distribution phase is the beginning of the end or, in other words, the origin of the bearish market. Thus, after ‘whales’ close their long positions, they start entering the hot market, opening short positions. ‘Whales’ make the overbought market drop, provoking the panic of uninformed traders. Some of them quit the market, while others still deny the end of bullishness, holding losing positions. The distribution phase acts as a painful reality check for most market participants and brings them devastating losses.
Thus, to get out of this hell, we recommend you to look sharp for reversal trend signs. It can be the price that makes lower lows (late December 2017 and early 2018) and lower highs, divergence in technical indicators, price consolidation or reversal technical analysis patterns (for instance, head and shoulders or double top).
It all brings us to the conclusion that the market is driven by ‘whales’ and human emotions. Undoubtedly, they are not the only driving forces, as the price dynamics is more complex and depends on a variety of factors that are often unique for each asset. And it’s also obvious that some of the market players win, while others suffer losses (this is how the market works), however, the understanding of the basic market mechanisms and psychology of the market players is likely to give you a tremendous advantage over other market participants.
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