The Psychology of Market Cycles

What is market psychology?

Market psychology is the idea that the movements of a market reflect (or are influenced by) the emotional state of its participants. It is one of the main topics of behavioral economics - an interdisciplinary field that investigates the various factors that precede economic decisions.

Many believe that emotions are the main driving force behind the shifts of financial markets. And that the overall fluctuating investor sentiment is what creates the so-called psychological market cycles.

In short, market sentiment is the overall feeling that investors and traders have regarding the price action of an asset. When the market's sentiment is positive, and prices are rising continuously, there is said to be a bullish trend (often referred to as a bull market). The opposite is called a bear market, when there is an ongoing decline in prices.

So, the sentiment is made up of the individual views and feelings of all traders and investors within a financial market. Another way to look at it is as an average of the overall feeling of the market participants.

But, just as with any group, no single opinion is completely dominant. Based on market psychology theories, an asset's price tends to change constantly in response to the overall market sentiment - which is also dynamic. Otherwise, it would be much harder to make a successful trade.

In practice, when the market goes up, it is likely due to an improving attitude and confidence among the traders. A positive market sentiment causes demand to increase and supply to decrease. In turn, the increased demand may cause an even stronger attitude. Similarly, a strong downtrend tends to create a negative sentiment that reduces demand and increases the available supply.

How do emotions change during market cycles?

Uptrend

All markets go through cycles of expansion and contraction. When a market is in an expansion phase (a bull market), there is a climate of optimism, belief, and greed. Typically, these are the main emotions that lead to a strong buying activity.

It's quite common to see a sort of cyclical or retroactive effect during market cycles. For example, the sentiment gets more positive as the prices go up, which then causes the sentiment to get even more positive, driving the market even higher.

Sometimes, a strong sense of greed and belief overtakes the market in such a way that a financial bubble can form. In such a scenario, many investors become irrational, losing sight of the actual value and buying an asset only because they believe the market will continue to rise.

They get greedy and overhyped by the market momentum, hoping to make profits. As the price gets overextended to the upside, the local top is created. In general, this is deemed as the point of maximum financial risk.

In some cases, the market will experience a sideways movement for a while as the assets are gradually sold. This is also known as the distribution stage. However, some cycles don't present a clear distribution stage, and the downtrend starts soon after the top is reached.

Downtrend

When the market starts to turn the other way, the euphoric mood can quickly turn into complacency, as many traders refuse to believe that the uptrend is over. As prices continue to decline, the market sentiment quickly moves to the negative side. It often includes feelings of anxiety, denial, and panic.

In this context, we may describe anxiety as the moment when investors start to question why the price is dropping, which soon leads to the denial stage. The denial period is marked by a sense of unacceptance. Many investors insist on holding their losing positions, either because "it's too late to sell" or because they want to believe "the market will come back soon."

But as the prices drop even further, the wave of selling gets stronger. At this point, fear and panic often lead to what is called a market capitulation (when holders give up and sell their assets close to the local bottom).

Eventually, the downtrend stops as the volatility decreases and the market stabilizes. Typically, the market experiences sideways movements before feelings of hope and optimism start arising once again. Such sideways period is also known as the accumulation stage.

How do investors use market psychology?

Assuming that the theory of market psychology is valid, understanding it may help a trader to enter and exit positions at more favorable times. The general attitude of the market is counterproductive: the moment of highest financial opportunity (for a buyer) usually comes when most people are hopeless, and the market is very low. In contrast, the moment of highest financial risk often arises when the majority of the market participants are euphoric and overconfident.

Thus, some traders and investors try to read the sentiment of a market to spot the different stages of its psychological cycles. Ideally, they would use this information to buy when there is panic (lower prices) and sell when there is greed (higher prices). In practice, though, recognizing these optimal points is rarely an easy task. What might seem like the local bottom (support) may fail to hold, leading to even lower lows.

Technical analysis and market psychology

It is easy to look back at market cycles and recognize how the overall psychology changed. Analyzing previous data makes it obvious what actions and decisions would have been the most profitable.

However, it is much harder to understand how the market is changing as it goes - and even harder to predict what comes next. Many investors use technical analysis (TA) to attempt to anticipate where the market is likely to go.

In a sense, we may say that TA indicators are tools that may be used when trying to measure the psychological state of the market. For instance, the Relative Strength Index (RSI) indicator may suggest when an asset is overbought due to a strong positive market sentiment (e.g., excessive greed).

The MACD is another example of an indicator that may be used to spot the different psychological stages of a market cycle. In short, the relation between its lines may indicate when market momentum is changing (e.g., buying force is getting weaker).

Bitcoin and market psychology

The Bitcoin bull market of 2017 is a clear example of how market psychology affects prices and vice-versa. From January to December, Bitcoin rose from roughly $900 to its all-time high of $20,000. During the rise, market sentiment became more and more positive. Thousands of new investors came on board, caught up in the excitement of the bull market. FOMO, excessive optimism, and greed quickly pushed prices up – until it didn't.

The trend reversal started taking place in late 2017 and early 2018. The following correction left many of the late joiners with significant losses. Even when the downtrend was already established, false confidence and complacency caused many people to insist on HODLing.

A few months later, the market sentiment became very negative as investors' confidence reached an all-time low. FUD and panic caused many of those who bought close to the top to sell near the bottom, incurring in big losses. Some people became disillusioned with Bitcoin, although the technology was essentially the same. In fact, it is being improved continuously.

Cognitive biases

Cognitive biases are common thinking patterns that often cause humans to make irrational decisions. These patterns can affect both individual traders and the market as a whole. A few common examples are:

Confirmation bias: the tendency to overvalue information that confirms our own beliefs, while ignoring or dismissing information that runs contrary to them. For example, investors in a bull market may put a stronger focus on positive news, while ignoring bad news or signs that the market trend is about to reverse.
Loss aversion: the common tendency of humans to fear losses more than they enjoy gains, even if the gain is similar or greater. In other words, the pain of a loss is usually more painful than the joy of a gain. This may cause traders to miss good opportunities or to panic sell during periods of market capitulation.
Endowment effect: This is the tendency for people to overvalue things that they own, simply because they own it. For example, an investor that owns a bag of cryptocurrency is more likely to believe it has value than a no-coiner.

Closing thoughts

Most traders and investors agree that psychology has an impact on market prices and cycles. Although the psychological market cycles are well known, they are not always easy to deal with. From the Dutch Tulip Mania in the 1600s to the dotcom bubble in the 90s, even skilled traders have struggled to separate their own attitude from the overall market sentiment. Investors face the difficult task of understanding not only the market's psychology but also their own psychology and how that is affecting their decision-making process.