Psychology of Market Cycles

In one of the previous articles we talked about the fact thatWhat drives financial markets?Today, to broaden our understanding of the topic, we'll discuss the psychological aspects that drive people to buy and sell. How do participants' emotions influence market processes and asset prices? How can emotions be prevented from interfering with sound investment decisions? We'll discuss this in our article today.

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Market psychology is based on the idea that the dynamics of market cycles depend largely on the emotional state of its participants. Emotion is the driving force behind behavior, including financial behavior. For example, when the overall mood is optimistic, investors find it difficult to resist buying, and as a result, prices will rise. This market dynamic is called a bullish trend.

A cautious or negative mood among market participants encourages selling pressure and, consequently, lower prices. This trend is called a bear market.

The mood depends on the personal views and feelings of all participants in the market process – the general feeling of the participants.

But, as we know, there is no absolute dominance of any one opinion or trend. Just as a bearish trend can have periods of growth, so a bullish trend can have periods of price decline. Asset prices constantly change in line with changes in overall market sentiment, which is also difficult to call a constant.

If the market is rising, its participants are confident that the growth will continue. Investors' positive sentiment creates excitement, increasing demand and reducing the number of offers on the market. And the greater the demand, the more people are willing to buy, and, consequently, the higher the price. A downtrend works similarly. When people see other participants dumping assets en masse, their natural conformity pushes them to do the same. Ultimately, the large number of offers on the market causes prices to fall, and the fear of an even lower price pushes them to sell faster. The cycle continues.

How emotions influence the market

Growing market

Market cycles are like a heartbeat—alternating contraction and relaxation. Contraction and tension characterize a bear market. Relaxation, upswing, optimism, faith in future growth, and a thirst for profit characterize a bull market. During this period, buying activity increases.

And here an interesting pattern emerges: rising asset prices stimulate positive sentiment, which in turn fuels even greater price increases. The situation heats up, and the thirst for profit can take hold of the market so completely that investors enter a kind of emotional state. They lose their realistic assessment of the situation and are willing to buy assets at ever-increasing prices, believing that they will continue to rise at the same rate. A financial bubble forms, which is simply bound to burst.

Traders in a frenzy become almost obsessed with potential future profits. At some point, the price reaches a critical risk point.

Sometimes, after reaching this point, the market freezes in a period where the price is stagnant and assets are gradually sold off—the distribution phase. Sometimes this phase is absent, and the price begins to fall immediately after reaching the peak.

A declining market

Not everyone notices the beginning of a market decline right away. Many traders find it hard to believe that the uptrend is over. But when the price decline can no longer be ignored, the overall sentiment begins to take on a negative tone. Markets, like people during periods of unexpected change, go through Elisabeth Kübler-Ross's five stages of acceptance:

• negation;
• anger;
• bargain;
• depression;
• acceptance.

It all begins with a nagging sense of anxiety at the first sign that the asset's price has fallen. This is followed by a stage of denial, fueled by the hope that the price will soon rebound. This is where cognitive biases, which we'll discuss later, come into play. These biases cause investors to hold on to assets, and they sell too late, incurring losses.

When prices fall further, a wave of selling begins, driven by the fear of losing their investments. This forces traders to accept the loss of income and capitulate, dumping their assets at prices somewhere around the price bottom.

Sooner or later, as volatility—the degree of price fluctuation—decreases, the downtrend ends and the market stabilizes. Typically, before the market begins to rise again, it enters an accumulation phase. This phase consists of the following decline, when trading whales close their profitable positions, the price movement is no longer supported by new supply, and the price ends its momentum, entering a state of consolidation—equilibrium. This equilibrium is determined either by supply and demand parity or by the absence of most market players.

How can knowledge of market psychology help?

Understanding the psychology of market cycles helps you spot the beginning of a trend and buy and sell assets at the most opportune times. When it's tempting to follow the crowd, it's worth stopping and remembering that herd instinct is counterproductive, and the most profitable buying times occur when most traders are panicking and selling assets. Conversely, the risk of losing money is greatest precisely when most people are confident that the price will continue to rise.

Guided by knowledge of the market cycle and human behavior at different stages, traders can find the strength to resist panic, approach the process thoughtfully, determine the stage of the market cycle, and, for example, go against the crowd and buy assets at a low price during a period of massive selling, and then sell them at a time of active price growth.

In theory, of course, everything is much simpler than in reality. And in practice, identifying optimal buying and selling points is quite difficult, even for experienced traders. What appears to be a price high or low may turn out to be an intermediate stage, and the actual price peaks will be higher or lower than expected.

Market Psychology and TA

As we've already discussed, understanding market psychology makes it much easier to ignore the panic of other participants and buy and sell at the most favorable moments. Analyzing the situation with a cool head makes it much easier to make the most profitable decisions.

The biggest challenge or difficulty is understanding when changes occur in the market. And it's even more difficult to predict what will happen next. To try to predict future trends, many investors usetechnical analysis(TA).

Technical analysis tools can, to some extent, gauge market sentiment. The relative strength index (RSI), for example, can show that an asset is overbought due to optimistic sentiment.

Another indicator used to determine psychological market influences is MACD (Moving Average Convergence Divergence). This indicator is used in technical analysis to assess and forecast price fluctuations on exchanges. Fluctuations that signal changes in market dynamics—for example, a decline or increase in demand—help determine the psychological stage.

Market Psychology and Bitcoin

A prime example of the influence of psychological factors on price formation is the Bitcoin bull run of 2017. Over the course of a year, the price of Bitcoin increased from approximately $900 to $20,000. As the price rose, so did the euphoria of market participants. Many new participants emerged, lured by Bitcoin's rapid rise. Fear of missing out, a lack of critical thinking, excessive optimism, and a thirst for profit fueled the rapid price rise. And for some reason, it seemed the rise would continue. But then, the obvious yet unexpected happened.

In early 2018, the bullish trend began to shift to bearish. But even when a downward trend was clearly visible, many people, stuck in denial, remained in hold. Only months later did the majority of traders recognize the downward trend. The overall mood shifted to an extremely negative one. Fear gripped people, and then panic, which forced many who had bought cryptocurrency at its peak to sell it at the bottom, suffering large losses. After experiencing a severe shock, many investors became disillusioned with cryptocurrency and swore off its use in the future. However, this is simply a matter of the onset of the next stage of the market cycle and the influence of sentiment.

Cognitive distortions

These are stereotypical thinking patterns that influence ill-considered, seemingly irrational decisions. Such stereotypes can influence both the behavior of individual participants and the financial market as a whole.

Here are some examples of cognitive distortions:

• We tend to trust information that aligns with our beliefs and ignore information that contradicts them. Investors, for example, may look for confirmation that a bullish trend will continue and ignore signals that a bearish trend is beginning.
• The fear of losing money or property is stronger than the desire to gain. For example, under the influence of this cognitive distortion, a trader will panic-sell assets at rock-bottom prices during a price decline, losing the opportunity to profit by riding out the downtrend.
• We tend to overvalue the things we own simply because they're ours. For example, an investor who owns cryptocurrency has more faith in its reliability than someone who doesn't.

Resume

Believe it or not, market sentiment influences cycles and asset prices. Even with an understanding of psychological market cycles, it's difficult to go against the grain. Even experienced traders can find it difficult to resist the general mood and follow their own judgment when the majority of investors are buying assets in euphoria or, conversely, selling them in panic. Investors face the difficult task of studying not only market psychology but also understanding their own psychology and the reasons behind their decisions.

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