The Three Phases of a Rally

As the market heads higher, there seems to be growing enthusiasm that stock prices will just keep on rising.

But the reality is that the longer an advance continues, the tougher gains are to come by.

Take the current rally, for instance.

I've broken it down into three phases and labeled them in the chart below, which is a daily graph of the Nasdaq 100 Trust (QQQQ - commentary - Cramer's Take). First, let's take a look at what these phases are.

Phase 1 is the bounce phase, the upward thrust that reverses the prior downtrend and establishes the bottom. This phase has the fewest market participants playing initially, but with substantial resources on the sidelines, the bounce seems to draw the quickest response. When traders and investors recognize that "the bottom is in," they throw money at the market. Phase 1 is the most dynamic phase, as gains occur the fastest.

Phase 2 is the trend-following phase. After the initial thrust off the bottom, the market begins to work higher. Feeling safe that the bottom is in place, market participants now want in, but they are reluctant to get in unless the market gives them a pullback.

Being the uncooperative beast that the market is, pullbacks in strong markets frequently don't happen. For fear of missing out, market participants take a leap of faith that prices will continue higher, and they gradually tiptoe into the market. In Phase 2, gains can be substantial, but they generally occur over a longer period of time than Phase 1.

Phase 3 is the "get me in at any cost" phase. Or, as some market pundits loudly proclaim, "If you don't buy right here and now, you will be missing out." By the time prices reach Phase 3, the smart money has already made its profits and is looking for the exit. Furthermore, there is less money on the sidelines to lead to a sustainable price move. Price gains during this phase are generally less than phases 1 and 2. If price gains are achieved, they are most easily given back.

You can track these phases in the Nasdaq 100 Trust chart:

Tracking the QQQQ Here's where the rally's phases took place

Click here for larger image.

Source: TradeStation Chart Analysis

For the current rally, Phase 1 took place from the low close on July 21 to Aug. 17. Phase 2 goes from Aug. 17 to Oct. 16. Being generous, we will assume that Phase 3 ended at the Nov. 22 highs. I have summarized the data, along with calculated gains, in the table below.

By the Numbers Here's how the phases played out in terms of gains

Click here for larger image.

Source: TradeStation Chart Analysis

As you can appreciate, the strongest gains -- those that occur with the greatest ease or velocity -- happen during Phase 1. Phase 3 has the most reluctant gains, and as I've mentioned, Phase 3 is the hardest part of the cycle in which to hold on to gains. Monday's price action surely would attest to that fact.

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At the time of publication, Lerner was net long QQQQ, although holdings can change at any time.

Guy Lerner is an anesthesiologist and freelance writer who trades for his own account. He blends technical and fundamental analysis to find factors that lead to sustainable moves in the markets. Lerner's approach is research-driven and focuses on supply-demand issues, investor sentiment, intermarket relationships and monetary liquidity. He is a member of the Market Technicians Association and is the founder of TheTechnicalTake.com, a Web site that offers content, commentary and strategies for investors and traders. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. He appreciates your feedback and invites you to send your comments by clicking here.