The Psychology of Market Cycles
How emotions change impact market cycles and what it means for investors.
The Psychology of Market Cycles
As much as trading decisions are determined by well-thought-out strategies and adhering to various theories, there's still a considerable aspect dominated by emotions and sentiment. Traders in various economic markets today almost always allow their emotions to get the best of them, regardless of the asset they're investing in.
From the start, these investors stick to critical market analysis, observing the trend of market cycles and building from there. After that, they begin to realize the dominance of cyclical market cycles and tweak their strategies to reflect this.
This article will explore how emotions change and impact market cycles and what it means for investors.
What are Market Cycles?
Market cycles refer to trends or patterns that form over time within various market ecosystems. They can also be said to be the duration between the two most recent highs or lows of a standard benchmark.
New market cycles don't just emerge randomly. They start when patterns form in specific market sectors. These trends usually stem from factors linked to innovation or market regulations. Analysts can only usually identify a market cycle after it has ended. At its midway point, it is nearly impossible to know when it started and where it will culminate.
Depending on the market being analyzed, a market cycle can be as short as a few minutes or extend into several years. For example, day traders can consider ten-minute intervals, while real estate investors will likely assess longer periods (up to 20 years) to get an accurate overview of the market cycle.
What is Market Psychology?
Market Psychology refers to the patterns and movements that occur within a market, stemming from the emotional state of the participants or investors. In other words, market psychology is the idea that market movements are influenced and also reflect investors' emotional states.
It is a major aspect of behavioral economics and is heavily linked to the fluctuating investor sentiment that determines psychological market cycles. In the world of investment, it is widely believed that investor sentiment is a significant reason for the rise and fall of asset prices. Nevertheless, it is vital to note that investor sentiment is hardly singular. That is, there are several conflicting sentiments at any point in time.
Thus, market psychology is not necessarily the dominance of a single sentiment but rather a response to the aggregated or average market sentiment.
Bullish market runs are the result of positive sentiment, while a bear run is linked to negative investor emotions. With bullish runs, the upward trend results in increased demand, reducing supply and driving prices high. The opposite is the case with bearish market runs, as the supply of low-demand assets inevitably causes prices to drop.
What are The Stages of a Market Cycle?
In every market cycle, there are four stages:
This stage runs parallel to the end of a previous market cycle, typically at the culmination of a bad market run.
Here, things slowly begin to pick up, with inside investors and early adopters sharing the sentiment that the worst of the bear run is over. Now, they start to buy new assets, enjoying rather low prices due to the reduced demand and still dominant bearish market outlook.
Nevertheless, the overall market sentiment now slowly begins to lose its negativity, gradually turning out somewhat neutral.
This is the phase where the market has remained relatively stable for some time and is now slowly moving in an upward trend. Prices gradually increase as more investors become brave enough to test the waters, either for fear of missing out or simply greed.
As this phase ends, the greater fool theory begins to prevail, with early investors sitting back to enjoy the high prices and asset prices climbing beyond their intrinsic values. Interest in assets is now high, as the overall market sentiment now becomes bullish.
In this phase, early adopters and market insiders begin to sell off assets as market liquidity becomes high. However, distribution phases tend to be short, with market sentiment quickly reverting to a downward trend. The dominant sentiments are often mixed, ranging from greed to fear and hope.
Now, the market has become downright bearish. However, many investors still hold their positions, hoping that fortunes will be reversed.
However, things become clear when the market has dipped beyond 50%. Then, these, often late-entry investors (investors who bought in the distribution or late markup phase) finally have no choice but to sell off their assets at significant losses.
How do Investors Use Market Psychology?
An investor with a keen understanding of market psychology can use it to take advantage of bullish runs and mitigate the effects of a negative bearish market by holding favorable positions in the market.
Without this knowledge, the default market attitude prevails – entering a market position only when there's a boom. Per market psychology, such booms tend to come just before the end of the cycle, thus counterproductive for investors.
Rather, market psychology knowledge can help investors identify the point in a bearish market run where the time is right for early investment in potentially rewarding assets.
Alternative Forms of Market Analysis
Even despite knowledge of market psychology, one will agree that it can be hard to determine where a market is in terms of its cycle. As previously emphasized, these cycles are often only identifiable after they have long passed.
Some investors use TA (technical analysis) indicators to assess the market's psychological state. For example, the RSI (Relative Strength Index) may highlight the point where there is an overwhelming demand for assets due to excessive greed. Another similar indicator is the MACD (Moving Average Divergence Convergence), used in crypto and stock trading.
Observing the Crypto Market Cycles
The accumulation, markup, distribution and markdown phases of the psychological market all apply to the cryptocurrency market. Like it is in the stock market, there are analytical tools to help crypto investors observe these classic cycles. There are two ways to go about it:
On-chain Market Data
Crypto traders can observe the subtle shifts in the market cycle by visiting the on-chain market data platforms to access real-time and historical prices in comprehensive infographic detail.
In crypto trading, indicators like the Fear and Greed Index, Bitcoin Rainbow Chart and Ethereum Rainbow Chart are often reliable indicators for long-term predictions.
Understanding market psychology can help investors to place themselves in favorable positions better when exiting and entering the market. The best opportunity may arise at the height of a bearish run, as negative sentiment can foster hopelessness and, subsequently, low asset prices. Simultaneously, huge financial risk may come when market sentiment has a highly positive outlook.
It is thus important to understand how emotions affect traders, often turning the most logical thinkers into irrational investors. The market is always changing, and external events often affect the market outlook. How investors deal with it will strongly continue to be a matter of sentiment, no matter what.