In an upcoming post, I’ll explain that understanding market sentiment and the psychology of other investors in the market is far more useful than technical or fundamental analysis in a bear market. Here’s a wonderful chart of investor sentiment during a bear market. Look below to the right.
In this post, I will detail out exactly what each of these market stages are, and how investors are feeling (what the sentiment is) during each of these market stages. Through understanding psychology, one can predict how other investors will react to certain market events (because human psychology is the one thing that never changes, unless we stop being human).
At this stage, many investors are feeling good about themselves and the markets. It’s been a while since the markets touched bottom, and a lot of people have forgotten that equities were once deemed as “dead”. The public begins to buy (albeit not too much, afraid that stocks will fall), believing the propaganda from the main stream media proclaiming that stocks will go higher, Higher, HIGHER! A few market analysts are calling a bubble, the general atmosphere amongst investors is optimism. The market data is all good.
This is when things really start to roll. Good times are in, and the public becomes accustomed to buying ever increasing stocks. Most investors are buying with both hands now, believing that stocks have yet to double and triple and quadruple. In other words, bubble on! Risk on! A few of the smart investors and hedge fund managers, contrarian to popular belief, believe that it’s now time to short equities and pop the bubble. But of course, no one listens to them, because no one wants to be a disciple of bad news. Market data, of course, comes in with corporate earnings report consistently beating the previous ones.
This is when almost everyone in the markets have become a steadfast believer that the markets will continue to soar, “forever”! Isn’t that wonderful! Dow 2 million! Companies are posting record profits, and corporate biggies are selling crap from their PR machine like “we’ll increase revenue by 25%, year after year, forever!” Stocks analysts are writing down ever increasing estimates of higher and higher stock valuations. Buy now before it’s too late! Don’t miss out on the boom! And the problem is, 99% of investors get caught by all the wonderful music! That is, until the music stops. At the top of a bubble, the markets often experience high volatility and huge intraday fluctuations. The public is still buying like there’s no tomorrow, but many big insiders and fund managers are selling stocks by the shovel.
Uh oh. A few corporations have reported worse than expected earnings. Stocks have languished for a few months, going nowhere, which certainly isn’t what stocks are supposed to be doing when they’re “going up forever”. But no worries, guys! The analysts and “economic gurus” are still saying that this is just a temporary stall, so buy now while you still can!
It’s been more than a few months, and stocks have fallen off a bit. The public (average investors) keeps lieing to themselves, denying that the bubble is over. Sorry guys, party’s over. Go home. This is the stage when a bunch of good news comes out, but it’s mixed in with a bunch of bad news. The public, thinking that they’re being smart, decide to follow Buffett’s “buy when others are fearful” advice, and buy equities, believing that they’re getting a bargain. It’s a bargain all right, until you eventually realize that you got a bargain at bubble prices.
The savvy investors are getting out of the markets (selling), while they can. The mix of good and bad news causes the public to believe that they should buy on the dip, which gives a last chance to the sophisticated investors to sell, before everything goes downhill. Volatility during this stage is intense, because the insiders and sophisticated investors are selling by the shovel, while the public is buying by the shovel. Also, there are usually a few minor rebounds at this stage of the market cycle, purposely created by the insiders to fool the public into thinking that stocks are ready to continue rising.
This is when things start getting scary. The public can’t be fooled forever, and eventually, they sense that things aren’t going they way they should (a little too late though). The public is getting kind of scared now, because their portfolio is decreasing in value! More and more bombshell pieces of bad economic and corporate news comes out. All the fund managers and large investors are desperately trying to sell now, before prices fall lower. Their selling only causes market liquidity to dry up even faster and stock prices fall faster. The shorts have initiated their positions.
The public is dumbfounded. They simply don’t know what to do. Should they sell now, and potentially miss the eventual rebound in stock prices? Should they hold onto their investments, and potentially get creamed in the continuing blood bath?
It now seems like companies that were once deemed perfectly find are failing and going bankrupt at the rate of a few each day. There is absolutely no confidence left in the financial markets. The press is proclaiming the “death of equities”, and everyone is selling like crazy (including the public) as if stocks will fall to zero tomorrow. The markets completely discount any good economic news that comes out, and with every flood of bad news, the markets sell harder.
Stocks have gone down to a level that no one a year or so ago could have imagined. The smart investors are buying here, while the public is having nightmares of the bear market swiping money away from them.
Depression – Relief
The smart, sophisticated investors realize that the bloodbath is over, and the bulls are ready to roll out. Meanwhile, economic data is improving, and the markets are no longer fearful. However, the public is still scared to death by their recent experience, hence decide to hold off of buying equities.
Optimism – Excitment
….. And the market cycle continues. There will forever be panics, forever be bubbles, and forever by the same investor emotions.