All securities go through four distinct phases. Each phase has distinctive characteristics, and, as such, should be traded differently. These phases are: basing, bull market, topping, and bear market. Interestingly, I have discovered through practical experience that these four phases exist over various timeframes. Thus, day traders can identify these phases on an intraday chart, and longer-term traders can identify the four phases over longer scales on weekly or even monthly charts. I focus on the identification of these phases over longer periods (weeks and months), but the concept of each phase remains the same for all timeframes. Only by recognizing which phase a security or broad market is in can you plan and execute a profitable trading strategy.
Phase one is the basing phase. During this phase, the market is forming a bottoming pattern. Informed buyers, who I like to call the "smart money," are beginning to buy stocks off of frustrated sellers. Pessimism rules and trading volume is fairly low due to a lack of participation by the retail investing public. When the security breaks out of a phase one consolidation pattern, it will move up through the overhead "resistance" level and stay there. Phase one bottoming patterns include "head and shoulder bottoms," "double bottoms," "rounded bottoms," and others.
Phase two is the bull market phase. The security (or market) has entered into a new phase of bullish price movement that will usually last for many weeks or months. Along the way, there will be plenty of rising peaks and troughs. As the market begins to move higher, draw a trendline connecting the first three rising troughs. Near the end of a phase two uptrend, peaks and troughs will become more erratic in their rhythm-the time elapsed between each peak starts to vary, and price movement between peaks and troughs becomes greater and greater. Volume may increase aggressively as the trend nears its end. The market is becoming overly confident in the long-term outlook for the market. Eventually, the market will move into a phase three topping pattern, and it will soon be time to get out of your long positions.
Phase three is the topping phase. Similar to phase one, this is a trading range market. But this phase occurs after a long bull run on a security. After breaking the trendline from phase two, the market forms topping patterns. These formations are often a mirror image of phase one patterns. News stories and earnings reports are favorable, supporting the conviction of the believers of the bull market. Eventually, as the stronger, smarter money finishes dumping their positions into weaker hands, a piece of news or fundamental event will occur that will trigger a sharp drop in price over a very confined period of time and "support" is broken. The security will now be moving into the bearish phase.
Phase four, the final phase of a typical market pattern, is the bearish phase. Just as a phase three top can be the mirror image of a phase one bottom, the bearish phase of the market is a mirror image of the phase two bullish phase. Phase four downtrends are, when compared to an uptrend, fast and furious. The bear phase will exhibit declining peaks and troughs. The chart I've presented here shows you the four phases of the market that have taken place since the March 2009 market bottom. As you can see, the new phase four bear market began when the rectangular phase three top broke in the fall of 2011. My book, Sideways, outlines details on how to identify and invest within each of these phases. During my Vancouver MoneyShow presentation, I will provide further insight on trading within the current phase four bear trend environment.
