1. What are market trends and how are they formed?
Economic and business cycles constantly change. As one cycle weakens, the next one strengthens and takes over. After a period of time, it too weakens and is overtaken by the next, and so on and so on. Think of these cycles like waves on the ocean: ebbing and flowing, some larger, some smaller, some rushing onshore, some receding rapidly into the undertow - but always moving.
Prices of stocks, bonds and other investments also constantly move up and down in co-ordination with these cycles. When economic/business cycles are strong, we see rising stock prices. When economic/business cycles are weak, we see falling stock prices.
> When stock prices are rising during a strong cycle, the market is in an uptrend. This is also called a bull market. As long as the cycle stays strong, stock prices will continue to rise (that’s great if we are invested in stocks).
> When stock prices are falling during a weak cycle, the market is in a downtrend. This is also called a bear market. As long as the cycle remains weak, stock prices will continue to fall (that’s not good if we are invested in stocks).
There are times when markets are not trending at all. After a strong move (up or down), a market or individual stock’s price action may move sideways for a period of time as it “digests” its gains or losses. During these basing, or consolidation periods buyers and sellers reach a kind of equilibrium on price as each side waits for news that will reverse or continue the previous trend. Basing periods can last for a few days, a few weeks or a few years. That’s not good if we are holding an investment during those periods. Here’s why:
> As of this writing (November 2012), drug store stock Rite Aid (RAD) has moved in a sideways trend for more than 3 1/2 years. Since April of 2009, the stock has traded back and forth in a range between 85 cents and $1.85. Technically we could say that investors who bought RAD during that time haven’t lost any money on their investment…until you consider the “opportunity costs.”
Simply put, investors who chose RAD got no return for the better part of three years. They had the choice, or opportunity, to put their money into a lot of other stocks that were trending higher at that time and made good money (even a plain-Jane index fund would have outperformed RAD for that period!). That 3 years of “dead money” cost their portfolios dearly, depending on how large their RAD investment actually was.
Non-trending markets don’t always give us nice, quiet sideways price action. Many times the price action can be volatile and choppy. This is especially true during transition periods when major trends are in the process of changing. Choppy price action is a direct result of the battle being waged between the bulls and the bears at these turning points: one side trying to hang onto the current trend, the other side trying to reverse it. These are periods where major market tops and bottoms are formed.