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Market Psychology & Cycles That Repeat

As investors for the long term, market cycles are an inveitable part of the capitalist boom (expansionary monetary environment) and bust (contraction of credit) cycles that ebb and flow with the economy. Bull and Bear markets are a constant. History proves out for the last hundred years that the overall market trajectory is up, so if you are investing for the long term you dont have to worry providing you are not relying on the market for a significant part of your monthly income. For long term investors who dont need to draw down on their portfolios for income purposes, the psychology to adopt is: "ignore market downturns" and "continue to live your life." The markets will come back. The last hundred years proves they always do!

For strategic traders who want to take advantage of transitions from Bear to Bull Markets or Bull to Bear markets, market psychology can prove a valuable tool (among others) to gauge when to get out or get in.

So what do market tops or bottoms have in common?

The Emotional Psychology of Market Tops

Investor optimism is almost always euphoric at market tops. The only direction is Up! Valuations of market leaders often defy logic, but the promise of continued gains seems all but guarranteed. The last segment of every bull market often referred to as a "melt-up" phase can be one of the most profitable, especially among the hottest sectors that have been at the forefront of the bull market. When optimism reaches such highs, it would be wise to start to think about selling. A useful indicator that can help identify such times (alongside other indicators) is the VIX index. When this is under 12 it signals that investors are very confident. Markets can continue to go up far longer than any one may think is possible or rational. However, it is precisely when things become too irrational that strategic traders should think about selling in phased increments. Will you lose some gains by doing so? The likely answer to this question is yes, of course, but in the words of Baron Rothchild, when asked what his secret was to making money, he replied: "I always sold too early"!

The Emotional Psychology of Market Bottoms

Conversely, market bottoms are often characterized by an end of the world mentality. The "Sky is falling" and there is no end in site. Panic and fear are the predominant mood and the news media will likely be fuelling this sentiment. Markets can go down further than any one thinks possible or is rational. It is during the period of extreme fear which you can measure using the VIX index (any value over 50 is signalling an extreme mood of fear and if it approaches 80, that would signal a bottom is approaching) that you might consider to begin buying. It is of course noting from a pyschology standpoint, this will be the moment when you will feel the least inclined to buy anything, so countering this emotion is a requirement and not easy of course.

It is always much easier to write about these matters than it is to enact them. The pyschology of acting counter-cyclically is very hard. It requires discipline, good nerves and a solid understanding of human psychology, technical analysis as well as historic market cycles and patterns.

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1600 South Main Street, Suite 190
Walnut Creek, CA 94596
Phone: 925-906-9800
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