Where as as the business cycle is an artificially created economic phenomenon, investor psychology is completely natural and so much of nature it cycles. Here is an excellent explanation of The Investor Psychology Cycle from Minyanville.
The Investor Psychology Cycle
Prieur du Plessis
As the pendulum swings between greed and fear, investors typically behave in 1 of 2 ways: They either become over-enthusiastic during bull markets and over-despondent as the bear’s growl grows louder.
It stands to reason that in order to be a successful investor, it's important to distance yourself from the herd mentality and to take objective decisions based on fundamental reasons.
The typical behaviour of investors is linked to the so-called investor psychology cycle (courtesy RMB Unit Trusts), as illustrated below.
Before seeking to apply the cycle to the present stock market situation, let’s consider a short definition of each of the stages.
- Contempt: According to the cycle, a bull market typically starts when a market is at a low and investors scorn stocks.
- Doubt and suspicion: They try to decide whether what they have left should be invested in a safe haven, such as a money market fund. They've burnt their fingers on stocks, and vow never to invest again.
- Caution: The market then gradually starts showing signs of recovery. Most remain cautious, but prudent investors are already drooling at the possibility of profit.
- Confidence: As stock prices rise, investors’ feeling of mistrust changes to confidence and ultimately to enthusiasm. Most investors start buying stocks at this stage.
- Enthusiasm: During the enthusiasm stage, prudent investors are already starting to take profits and get out of the stock market, because they realize that the bull market is coming to an end.
- Greed and conviction: Investors’ enthusiasm is followed by greed - often accompanied by numerous IPOs on the stock market.
- Indifference: Investors look beyond unsustainably high price-earnings ratios.
- Dismissal: As the market declines, investors show a lack or interest that quickly turns to dismissal.
- Denial: They then reach the denial stage, where they regularly affirm their belief that the market definitely cannot fall any further.
- Fear, panic and contempt: Concern starts to take hold; fear, panic and despair soon follow. Investors again start scorning the market. Once again, they vow never to invest in stocks again.
In order to determine where in the stock market cycle we find ourselves, the challenge is to identify the prevalent stage of the psychological cycle.
I would, for starters, argue that we are on the right-hand side of the curve - but how far down we find ourselves on that slippery slope is less clear. It would seem that we're possibly in the region of the denial/ fear/ panic phases.
Although enduring investor panic and fear haven't really set in, the January, March and July sell-offs did witness climatic -- albeit short-lived -- bouts of despair.
Time will tell whether we're dealing with a typical investor psychology cycle, and how it will play itself out. It does, however, seem that we are at not at the “contempt” stage yet, i.e. when investors scorn shares en masse and a bull market typically starts.
I do believe we are still in a primary bear market where stock markets are, at best, faced with a prolonged convalescence period characterized by sub-optimal returns. Whether significant further declines take place from these levels -- and whether valuations will overshoot to bargain levels, triggering bouts of panic and fear -- is anybody’s guess.
However, in the short term, I give the nascent stock market rallies the benefit of the doubt, provided the mid-July lows are sustained. For any rally to become more enduring, further base building will be necessary -- possibly wearing investors out to the point of contempt -- and an eventual shift in central bank policy to targeting GDP growth rather than inflation.
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