Investor Psychology Illustrated: Where Are We in the Cycle? ~ market folly

Thursday, April 29, 2010

Investor Psychology Illustrated: Where Are We in the Cycle?

It's funny how cycles work. Exactly one year ago we posted up a chart illustrating investor psychology. As we now look back, April of 2009 marked a time when the market had just bottomed and was in the nascent stage of a comeback. Today, we find ourselves in a completely converse situation. Rather than watch the market decline and decimate, we're now faced with a seemingly never ending market rally that some would label an anomaly of an ascension. Ahh the market cycle, don't you just love it? Investors have certainly experienced a wide array of emotions over the past few years. Behavioral finance has long been a compelling topic and if you're interested in learning more, we defer to hedge fund Blue Ridge Capital's recommended reading list.

One year ago, for whatever reason, we were compelled to post up a chart illustrating investor psychology. Today, one year later, we felt compelled again. Below you'll find the 17 stages of investor psychology ranging from rage to disbelief to euphoria. Here is how investors feel during the peak-to-trough market cycle:

(click to enlarge)

As you can see, there are 19 stages in the cycle. By all accounts, it would seem that we are currently somewhere between points 15 and 19 on the chart. Are we past the "what the hell???" stage yet? Some would argue that we passed that point at around 1,100 on the S&P 500. Some would also argue that we are at point 17 in the cycle, the "more crazies who are going to get taken to the cleaners" stage. Who knows.

While it's uncertain where exactly in the cycle we are, the point is that we're still in a cycle. Given that we posted this chart up exactly one year ago, we found it fitting to remind everyone of the various levels of mania an investor can experience. We do know this though: many have turned cautious. While he admits market timing is not his forte, legendary investor Jim Rogers recently started some short positions. Additionally, over the past few weeks, hedge funds have drastically reduced long exposure as the smart money's been selling equities. Lastly, we covered how market strategist Jeff Saut summoned the old market adage, "sell in May and go away" and then said don't wait 'til then to do so. Many will deem this as rational thinking given the run the market's had. At the same time, this all reminds us of stage 18 in the cycle where everyone thinks the correction is coming but then the market actually heads higher. In this liquidity driven environment, it certainly wouldn't be the first time.

Couple the above chart with this additional one from Prieur du Plessis, and you've covered the full spectrum of investor psychology:

(click to enlarge)

For more on this topic, we recommend you check out the compendium that hedge fund Blue Ridge Capital has assembled via their behavioral finance reading list. Ahh the market cycle, don't you just love it? Round and round we go. Where we'll stop, nobody knows.

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