Which part of the market cycle are you in?
Hi,
Today I woke up with the usual cold symptoms and almost caved in to not writing this letter.
Then I remembered my whys and mantras and pulled out some discipline from the corner.
It got me thinking about seasons, which can also be a synonym for cycles and obviously in our context market cycles come to mind.
The other day I saw again a graphic that I want to make sure never escaped you. It pokes fun at the psychology of traders and how they (mainly novices) react to the market.
Check it out.
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Remember how it is important to act and not react?
Notice in the graph how you can picture a person following those moods is purely reacting to emotions as one looks at the present market environment.
Making investing decisions based on emotions is how we end up following the herd and how we participate in reinforcing the bull and bear market self fulfilling prophecies.
Let’s follow the emotional states in the graph and see why they might arise:
- Disbelief: “This rally will fail like the others” -> We don’t even want to think about investing, we are still recovering from the past burns. We miss out on the best value plays.
- Hope: “A recovery is possible” -> We see others investing so we open up to the idea. We are out of routine so we need to get into it all again. We miss out on the best growth plays.
- Optimism: “This rally is real” -> We see the rising price trend and the news are starting to be positive. Time to find where to invest. What is the hottest trend that is driving the market? We miss out on the remaining safer plays.
- Belief: “Time to get fully invested” -> We are now subject matter experts on the market and go all in on the most hyped assets. We miss the chance to put in the first safety stops.
- Thrill: “I will buy more on margin. Gotta tell everyone to buy!” -> Everyone and their grandma start talking about investing. Everyone is a market expert. The most irresponsible invest leveraged (loans, margin, etc). Meanwhile value investors are taking profits and growth traders are getting ready to exit.
- Euphoria: “I am a genius! We’re all going to be rich!” -> Rationality left the house, we can only stare at our unrealised gains and dream of all the stuff we will buy. Meanwhile we lost the opportunity to take serious profits. The pro’s are now shorting the market.
- Complacency: “We just need to cool off for the next rally” -> We fail to see the market turned because overpriced and overbought. We won’t admit getting caught up in the hype and cannot accept minor losses on our unrealised gains. We miss our chance to get out with minor profits.
- Anxiety: “Why am I getting margin calls? This dip is taking longer than expected” -> We are unable to cut losses and start getting worried, we look to the rest of the market still believing it’s just a dip and do nothing.
- Denial: “My investments are with great companies. They will come back” -> We have now lost so much that we might as well hold it out we tell ourselves, it’s only unrealised after all. Pro’s have allocated their funds to other assets that are performing in the meantime.
- Panic: “Shit! Everyone is selling. I need to get out!” -> Out portfolio becomes to scary to watch, what if we need money? Better to have some than to have nothing.
- Capitulation: “I’m getting 100% out of the markets. I can’t afford to lose more” -> We start realising we got duped by emotions again. We materialise our losses making them real and painful.
- Anger: “Who shorted the market?? Why did the government allow this to happen??” -> We blame everyone and everything else but ourselves for our mistakes and fail to learn. We miss out on uncovering future opportunities because we are not focusing on staying in the game and learning.
- Depression: “My retirement money is lost. How can we pay for all this new stuff? I am an idiot.” -> Reality kicks in. We give up. We risk establishing negative thought patterns and succumb to scarcity mentality.
- Disbelief: “This is a sucker’s rally” -> Back to where we started. Now you know why. People without introspection and an interested in human nature and behaviour will fail to see the pattern and risk taking another ride through the cycle.
Obviously this is not exactly what happens, right?
Although more than we like to admit, we have experienced some of these stages ourselves at least once and hopefully learned the lessons.
It is a fun graph, but actually it is useful knowledge to keep in mind when we try to assess the market situation.
The difficulty is that the cycle is easy to identify in hindsight. The more time you spend in the market, the more experience you have, the more your gut gets trained to identify these stages.
So at what stage are we in now? Does it even matter?
Remember that good investors act, they don’t react. There are always opportunities in any market mood, you just need to learn to look for them.
Maybe some weekend thinking.
Have a good one,
Chris
Originally posted 13th October 2023 on ElliottSays.com
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