What it means
Share prices do not rise in a straight line. They tend to move in waves that reflect changing economic conditions, interest rates, company profits and investor mood.
A common description has four phases. In accumulation, informed buyers quietly build positions after a decline, in mark-up, prices rise as more people notice, in distribution, early buyers sell to latecomers near the top, and in mark-down, prices fall as selling spreads.
The pattern is a way of describing behaviour rather than a law of nature. The length of cycles varies widely, from a few months for short trading swings to many years for the large cycles known as bull and bear markets.
No one can reliably predict the exact turning points, so cycles are better used to frame decisions than to time them. Anyone claiming to know the exact top or bottom in advance should be treated with caution.
For a business, the cycle affects practical choices such as when to issue shares, when to offer staff share-based pay, and how to value a pension fund or an investment portfolio. A company that raises capital near a peak may get a better price for its shares than one raising money in a downturn.
The cost of capital (the return investors demand) also tends to move with the cycle. The mathematics of losses is worth remembering.
A fall needs a larger percentage gain to recover, so a long mark-down phase can take many years to repair. Diversification and a long time horizon are the standard ways to live with that.
In practice
Real-world examples.
Example
A finance director of a listed manufacturer notices that her company's shares have risen steadily for three years and are well above their long-run average valuation. She brings forward a share issue to fund a new plant, taking advantage of the high price. The cycle did not tell her the exact top, but it informed her timing.
Example
A pension fund manager reviews a portfolio after a long rally. Equities have grown from 55% to 70% of the fund, so he sells enough to return to the target of 60%. The rebalancing locks in gains without trying to call the top.
Example
A small retailer's owner holds a share portfolio for retirement. When the market falls 30%, she keeps her regular monthly contributions going, buying more shares at lower prices. Over the next cycle the lower purchases help her recover faster.
Formula
Calculation
Peak-to-trough decline = (peak price - trough price) / peak price
Gain needed to recover = (peak price - trough price) / trough price
A stock rises to a peak of $100 and then falls to a trough of $60. Decline = (100 - 60) / 100 = 40 / 100 = 40%. Gain needed to recover = (100 - 60) / 60 = 40 / 60 = 66.7%. So a 40% fall needs a gain of about 66.7% just to get back to where the stock started.Case study
Seen in the real world.
Meridian Tool Works is an illustrative, fictional listed company whose shares trade at $40 after a strong three-year rise. The board is considering a $20,000,000 share issue to fund a new factory, and the finance director shows the history of the share price across two earlier cycles.
She points out that in the last downturn the shares fell from $40 to $22 and took four years to recover. The board decides to issue half the shares now and finance the rest with a bank loan, so the company is not forced to raise equity at a low price if the cycle turns.
The cycle does turn within two years, and the shares drift to $28. The illustrative outcome is that the mixed funding saved the company from a painful issue at a low price, and the board agrees to review its capital plan against the cycle every year.
Watch out
Common mistakes.
- Assuming that a cycle can be timed precisely, when peaks and troughs are only obvious in hindsight.
- Believing prices must return to a previous high within a set time, when some recoveries take many years and some stocks never recover.
- Confusing the cycle of a single stock with the cycle of the whole market, when an individual company can fall during a rising market or rise during a falling one.
Questions
People also ask.
How long does a stock cycle last?
There is no fixed length, with short trading swings lasting weeks or months and broad bull and bear markets lasting several years.
What causes stock cycles?
They are driven by a mix of interest rates, economic growth, company profits and investor sentiment, which can reinforce one another and amplify moves.
Can I avoid the downturn phase?
Few investors can sell consistently at the top and buy at the bottom, so most people manage the risk through diversification, regular investing and holding enough cash for their needs.
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