How Does the Psychology of Market Cycles Work?

Basics

Market psychology is the theory that a market's movements reflect (or are affected by) the participants' emotional states. It is one of the key areas of study in the multidisciplinary discipline of behavioral economics, which looks at the different variables that influence economic decisions. It is believed that the primary reason underlying changes in the financial markets is emotion. And that the so-called psychological market cycles are a result of the generally changeable investor mood.

Market sentiment is the perception traders and investors have of an asset's price movement. When the market sentiment is positive, and prices are continually increasing, this is known as a bullish trend or a bull market. In contrast, the opposite situation is a bear market or a decline in prices. Market sentiment is the average of the overall feeling of the market participants, although no single opinion dominates.

Based on market psychology theories, an asset's price tends to change continuously in response to the overall market sentiment. It is necessary for traders to adapt their strategies as the market's sentiment changes to make successful trades.

An improving attitude and confidence among traders typically cause the market to rise. A positive market sentiment increases demand and decreases supply, resulting in a stronger attitude. Conversely, a strong downtrend generates a negative sentiment that reduces demand and increases the available supply, leading to further declines.

What Is the Impact of Market Cycles on Emotions?

During an uptrend characterized by optimism, belief, and greed, buying activity tends to increase. As prices go up, the sentiment becomes more and more positive, driving the market even higher. In some cases, a strong sense of greed overtakes the market, leading to a financial bubble where investors become irrational and lose sight of the actual value. When the market reaches the point of maximum financial risk, a local top is created, and a downtrend may begin.

During a downtrend, the euphoric mood of the uptrend can quickly turn into complacency, and market sentiment can become negative. Feelings of anxiety, denial, and panic often set in. Anxiety occurs when investors start questioning why prices are dropping, leading to the denial stage, where investors refuse to sell losing positions. But as prices continue to drop, fear and panic often lead to market capitulation, where holders give up and sell their assets close to the local bottom.

Eventually, the downtrend stops and the market stabilizes, often leading to a period of sideways movement or accumulation. The market then experiences hope and optimism, leading to an expansion phase or uptrend. The cyclical or retroactive effect during market cycles often leads to the sentiment becoming more positive as prices go up, causing the sentiment to get even more positive, driving the market even higher.

How Do Investors Employ Market Psychology?

Market psychology can be a valuable tool for investors in identifying favorable entry and exit points. Understanding the theory of market psychology can help traders make informed decisions based on the general attitude of the market. The highest financial opportunity for buyers often arises when most people have lost hope, and the market is low. Conversely, the moment of highest financial risk typically emerges when most market participants are overconfident and euphoric.

Investors use this knowledge to identify the different stages of the psychological cycles in the market, looking for opportunities to buy when there is panic (lower prices) and sell when there is greed (higher prices). However, recognizing these optimal points can be a challenge, as what may seem like the local bottom (support) can fail, leading to even lower lows.

Market Psychology and Technical Analysis 

While analyzing past data is easy, predicting future market cycles is challenging, and traders use TA to foresee market direction. Anticipating changes in market psychology and cycles is difficult, but technical analysis (TA) may be used to predict market direction. TA indicators are tools that traders use to measure market sentiment. For example, the Relative Strength Index (RSI) indicates when an asset is overbought due to excessive greed. Another example is the Moving Average Convergence Divergence (MACD) indicator, which measures changes in market momentum. By analyzing the relationship between the MACD lines, traders may predict changes in buying and selling pressure. 

The Impact of Market Psychology on Bitcoin 

Bitcoin's bull run in 2017 demonstrated the relationship between market psychology and prices. The cryptocurrency surged from $900 to $20,000 within a year. The increasing positive market sentiment attracted many new investors who became caught up in the excitement of the bull market. As FOMO, excessive optimism, and greed continued to drive up prices, the trend eventually reversed in late 2017 and early 2018. The correction that followed left many of the latecomers with significant losses. Despite the downtrend, some investors remained confident and refused to sell, believing in the popular mantra of "HODLing." As time passed, market sentiment turned very negative, causing many who bought close to the top to panic and sell at the bottom, incurring huge losses. This caused some disillusionment with Bitcoin, even though the technology continued to improve.

Cognitive Biases 

Common cognitive biases can lead to irrational decision-making for individual traders and impact the market as a whole. These biases include confirmation bias, where people prioritize information that aligns with their beliefs and disregard conflicting information; loss aversion, where the pain of a loss outweighs the pleasure of a gain; and the endowment effect, where people overvalue what they own. For instance, an investor with a cryptocurrency bag is likely to believe that it has value, even if it doesn't. Confirmation bias can lead investors to focus on positive news in a bull market and overlook negative signals that indicate a potential reversal. Loss aversion may cause traders to miss good opportunities and panic sell during market downturns.

Conclusion

Market psychology has an undeniable influence on market cycles and prices, as most traders and investors concur. However, navigating the psychological aspects of the market is no easy feat. Over the centuries, even experienced traders have faced significant challenges separating their emotions from market sentiment. From the Dutch Tulip Mania in the 17th century to the dotcom bubble in the 1990s, traders struggled to maintain objectivity amidst the hype and frenzy of the market. Investors must grapple with understanding their psychological tendencies and how they affect their decision-making process, as well as interpret market psychology.