Markets move in a four-stage cycle across multiple time frames. Markets are fractal in nature, meaning they can be broken down into smaller time frames, but they must follow this sequence.
Stage 1: Consolidation (Sideways Trend) – Uncertainty and Ambivalence
Stage 1 is a sideways trend that is typically narrow and often consolidates, meaning the range becomes even tighter over time. It is defined by equal highs and equal lows, though the lows generally start to ascend before a breakout into an uptrend.
Stage 1 usually develops after Stage 4, which we will cover later. The primary emotions during this stage are ambivalence and uncertainty, which eventually give way to optimism and greed as the market prepares to break out.
Stage 2: Uptrend – Greed
Stage 2 is an uptrend, characterized by higher highs and higher lows. It follows Stage 1 and is primarily driven by greed—as markets move higher, investors hold on in anticipation of further gains. In a greed-driven market, there is no strong reason to sell, aside from profit-taking.
However, once fear and uncertainty are introduced, investors rush to sell before others do, trying to protect their profits. The end of an uptrend is often marked by complacency, or what former Federal Reserve Chairman Alan Greenspan famously called “irrational exuberance.”
Stage 3: Distribution (Wide, Volatile Sideways Trend) – Uncertainty
Stage 3 is a sideways trend with a wide, volatile trading range. Some traders believe the market or stock will continue higher, while others are happy to take profits and exit.
During this phase, markets may make new highs, but these are typically shallow. Occasionally, new lows may also form, but they tend to reverse sharply back to the highs. As a result, Stage 3 is defined by erratic price movements, equal highs, and equal lows within a broad range.
One key indicator of Stage 3 is the appearance of larger-than-normal price bars and increased volatility. The prevailing emotion during this stage is uncertainty, which eventually turns into fear or panic as the market weakens.
Stage 4: Downtrend (Capitulation & Panic Selling) – Fear and Panic
Stage 4 is fast, and fear driven. When the breakdown from Stage 3 occurs, it happens quickly, trapping latecomers who bought in at the highs.
Stage 4 is characterized by lower highs and lower lows, with each new low being deeper than the last. As fear intensifies, markets often experience capitulation—a final wave of panic selling in which nearly everyone who is willing to sell finally does.
At this point, valuations and prices reach extreme lows, and the market transitions back into Stage 1—a period of complacency and ambivalence as investors recover from the chaos of Stage 4.
Back to Stage 1 Again… Uncertainty and Ambivalence
And so, the cycle begins anew, usually at a higher price level, as markets have a long-term tendency to be bullish over time.
Stage 1 is often marked by low market participation, as many retail investors remain cautious after suffering losses in the panic-driven Stage 4. However, from a long-term investing perspective, Stage 1 is often the best time to buy, as valuations are low and opportunities for growth emerge.
