Different Phases of Market (Dow Theory)
Dow Theory suggests the markets are made up of three distinct phases, which are self repeating. These are called the Accumulation phase, the Mark up phase, and the Distribution phase.
The Accumulation phase usually occurs right after a steep sell off in the market. The steep sell off in the markets would have frustrated many market participants, losing hope of any sort of uptrend in prices. The stock prices would have plummeted to rock bottom valuations, but the buyers would still be hesitant of buying fearing there could be another sell off. Hence the stock price languishes at low levels. This is when the ‘Smart Money’ enters the market.
Smart money is usually the institutional investors who invest from a long term perspective. They invariably seek value investments which is available after a steep sell off. Institutional investors start to acquire shares regularly, in large quantities over an extended period of time. This is what makes up an accumulation phase. This also means that the sellers who are trying to sell during the accumulation phase will easily find buyers, and therefore the prices do not decline further. Hence invariably the accumulation phase marks the bottom of the markets. More often than not, this is how the support levels are created. Accumulation phase can last up to several months.
Once the institutional investors (smart money) absorb all the available stocks, short term traders sense the occurrence of a support. This usually coincides with improved business sentiment. These factors tend to take the stock price higher. This is called the mark up phase. During the Mark up phase, the stock price rallies quickly and sharply. The most important feature of the mark up phase is the speed. Because the rally is quick, the public at large is left out of the rally. New investors are mesmerized by the return and everyone from the analysts to the public see higher levels ahead.
Finally when the stock price reaches new highs (52 week high, all time high) everyone around would be talking about the stock market. The news reports turn optimistic, business environment suddenly appears vibrant, and everyone one (public) wants to invest in the markets. The public by and large, wants to get involved in the markets as there is a positive sentiment. This is when the distribution phase occurs.
The judicious investors (smart investors) who got in early (during the accumulation phase) will start offloading their shares slowly. The public will absorb all the volumes off loaded by the institutional investors (smart money) there by giving them the well needed price support. The distribution phase has similar price properties as that of the accumulation phase. In the distribution phase, whenever the prices attempt to go higher, the smart money off loads their holdings. Over a period of time this action repeats several times and thus the resistance level is created.
Finally when the institutional investors (smart money) completely sell off their holdings, there would no further support for prices, and hence what follows after the distribution phase is a complete sell off in the markets, also known as the mark down of prices. The selloff in the market leaves the public in an utter state of frustration.
Completing the circle, what follows the selloff phase is a fresh round of accumulation phase, and the whole cycle repeats again. It is believed that that entire cycle from accumulation phase to the selloff spans over a few years.
It is important to note that no two market cycles are the same. For example in the Indian context the bull market of 2006 – 07 is way different from the bull market of 2013-14. Sometimes the market moves from the accumulation to the distribution phase over a prolonged multi-year period. On the other hand, the same move from the accumulation to the distribution can happen over a few months. The market participant needs to tune himself to the idea of evaluating markets in the context of different phases, as this sets a stage for developing a view on Market.