Market Cycles: What They Are and the Psychology Behind Them
“Trading doesn’t just reveal character, it also builds it if you stay in the game long enough.”
That’s a quote from Yvan Byajee, author of Paradigm Shift: How to Cultivate Equanimity in the Face of Market Uncertainty (2015). In a lot of ways, the saying can resonate with many of today’s traders. It talks about how emotions can get the best of any trader on the market, no matter what kind of asset we’re talking about.
Many investors may try to analyze market cycles and build from there, hoping to earn big-time profits in the process. Let’s get to it.
What are market cycles and how do they work?
Market cycles are patterns or trends that usually form over time with different markets or business environments. They’re the period between the two latest lows or highs of a standard benchmark.
New market cycles usually emerge when trends form in a particular sector/industry due to important innovation, brand new products, or a regulatory environment.
The thing about these trends is that they’re hard to identify until the period is actually over. When you’re in the middle of it, it can be challenging to identify a clear beginning and ending point of a cycle—which can often lead to confusion in regards to the assessment of trading strategies.
Market cycles can last from a few minutes to many years, depending on the market you’re analyzing. Different careers will often lead to looking at various aspects of the range. For example, day traders can look at five-minute intervals, while real estate investors will look at ranges up to 20 years in the past.
What is market psychology?
Market psychology is the theory that the movements that happen within a market are due to its participants’ emotional states. Many analysts believe that investor emotions are what drive prices up and down. The idea is that investor sentiment is what creates the psychology of a market cycle. Obviously, no single opinion will be completely dominant. Because of that, you see a lot of fluctuations in an asset’s price—it’s a response to the average market sentiment (which is also dynamic).
When the market’s sentiment is positive and the prices rise, it turns into a bull market. During this time, the demand for an asset increases, which results in a decrease in supply. That increased demand can create an even more favorable environment, driving the price even higher.
When the market sentiment is negative, it turns into a bear market. Demand is reduced while supply is increased. This increase in supply could create a downtrend that could make investors more cautious.
The stages of a market cycle
There are four stages in every market cycle:
Stage 1: Optimism, thrill, and then euphoria
The cycle always starts with an overall positive attitude. The first investment anyone makes is met with a lot of optimism. We commonly expect things to happen for us and get rewarded for our investment.
When the overall market has this attitude and a lot of investor’s expectations are met, it’s easy to get excited about even higher returns. This is when investors experience the thrill of trading.
When the cycle hits its peak, the investors begin to experience euphoria. At this point, we believe that we can do no wrong, that we beat the market—which makes this the most dangerous part of the cycle. This is the part where investors reach the point of maximum financial risk: we think that we are incapable of making mistakes and that we can tolerate higher levels of risk. We believe that excessive returns are inevitable.
Stage 2: Arrogance, denial, and fear (or hope)
Stage 2 is when the market suddenly stops meeting our new expectations of excessive returns. However, we stay confident and complacent (some might say arrogant) about the market returning to its rising state. The market starts to turn on us as, in denial, we frequently hear:
“I’m sure it’ll go back up.”
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“I won’t be phased, it’ll head back up for sure.”
This is where the anxiety begins. We start anxiously watching the market—hoping and praying for it to go back up. As soon as the value of our investments continues to decline, that anxiety quickly turns into fear. That fear can cause many investors to focus on their defense, transferring their assets to more defensive shares or asset classes. Others may continue to hold their losing positions and hope that the market will recover.
Stage 3: Panic
As the bull quickly turns into a bear, investors may become desperate and start panicking. All traces of confidence are now gone and investors are now looking to minimize losses. Some spirits will be crushed entirely, leaving them to wonder if the market will recover at all.
Stage 4: Caution
At this point in the market cycle, the lowest low is now over. There are rises once again in price, but the investors remain vigilant. They may exercise caution as they think about once again entering the market:
“Will this market growth last?”
“Prices are low, and the opportunities are enticing, should I invest?”
Back to stage 1
There is usually a period where the market experiences sideways movements (insignificant rises and drops). This can give investors enough time to build optimism and hope once again, eventually restarting the entire cycle.
Once investors have enough time to hop on that investment train, the sentiment can start to become positive once again and we’re back to stage 1.
Bitcoin and market psychology
The price spike of bitcoin in late 2017 is the perfect example of how market psychology affects an asset’s price. At the beginning of 2017, BTC price was set at around $900. Throughout the year, its prices spiked—eventually reaching its all-time high of about $20,000.
During this incredible rise, the market’s sentiment became more and more positive throughout the year. Because there was so much excitement during this bull run, thousands of new investors got in on the action, hoping to make big profits. There was a lot of FOMO (fear of missing out), greed, and excessive optimism. Those are what pushed the price to quickly rise—until it didn’t.
The decline began in late 2017/early 2018. A lot of people who joined late ended up experiencing significant losses. Many people insisted on HODLing (due to false confidence and complacency) and some haven’t recovered since.
Using market psychology to your advantage
Understanding market psychology can put you in better positions, both in entering and exiting the market.
For a buyer, his/her highest financial opportunity may come when the market is at its lowest. The negative sentiment of the market can break spirits, causing a sense of hopelessness and low prices for the asset. At the same time, the highest financial risk may come when the sentiment is at its most positive.
Although the concept is easy, seeing these points in the market cycle is not. High prices can still rise and what may seem like the bottom can go even lower.
The key takeaway is this: sometimes, emotions get the best of us. They can turn rational people into irrational investors.
Remember that the market is always in constant flux and investments will always go in and out of favor. Extraordinary events can cloud our judgment and we’ll all have our own ways of dealing with it—and that’s okay, because if investing were easy, everyone would be rich.