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4 Emotional Stages of Market Cycles

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For some of you this is a review, and for rookie traders what I write below is new information that I know is both accurate and a must-know for any trader.

The value of stock prices and thus stock market indices such as the S&P 500 and the Dow 30 literally move through four emotional stages. Those emotional stages are: 1) optimism; 2) euphoria; 3) hope; and 4) despair. These emotional stages will be a force on stock values in both the intermediate-term time frame (less than one year as I measure it) as well as the long-term time frame (one year or more). The financial press unwittingly at times will use these exact words to explain the overriding investor emotion as that emotion pertains to the movement and value of the stock market. You too will feel and sense that same overriding emotion as you either add or subtract from the capital and assets you allow to be risked in the stock market.

The optimistic stage is one of rising prices as new capital is put to work by current market participants as well as newly-joining market participants. How long this stage of the emotional cycle is in control of stock prices is dependent upon the success of that capital invested as well as the positive return on the capital risked. The time spent to create the positive return is another important factor which will determine how long the optimistic stage controls prices.

The euphoric stage is the one where and when prices reach their zenith for that particular cycle. Parabolic price increases for many stocks if not the major averages are symbolic of the stage of euphoria. Euphoria can be defined as an ephemeral and false feeling of well-being. The best fund managers use the stage of euphoria to close out longer term held positions, raising cash in the process. Experienced traders do not sell short in euphoria as they know the financially lethal power of an upward parabolic move in prices occurs in euphoria. This is especially such if that price advance is accompanied by a strong short squeeze. Instead the professional trader waits for the next stage of the emotional cycle to take control of prices. That stage is the one I label as hope.

The hope stage is the one where and when prices have not only stopped increasing, but have begun to recede. The hope stage is the one stage that must be understood as its power to deceive the bulls is almost omnipotent, and is certainly potent relative to trapping bulls into holding positions as they decline in value. Bernard Baruch when asked why he was such a great investor replied that it was because he always sold too soon. Thus he did not allow the hope stage to trap him in any long and profitable positions, choosing instead to exit his longs while euphoria was in control of emotions extant. Hope is the stage that offers the best time to short stocks. Those who do short during the hope stage know that the next stage of the emotional cycle, the last of the four stages, is where they can buy to cover and thus profitably close out their short sales. None other than Leonardo Da Vinci best described this stage when he said: "Vows begin where hopes die." Hopes die in despair.

The despair stage is the one where the bulls are emotionally spent and unfortunately for them have well overstayed their long positions that have severely declined in value. Despair is where and when short sellers are buying to cover, closing trades opened during the hope stage. Those stocks were sold short in the preceding hope stage at much higher prices than where they are covered in the emotional stage of despair. Despair can last a relatively short or long period of time. That time frame is dependent upon how much damage was done by what had caused the despair at its inception. Once despair has been overcome the stage is set for what follows once again--optimism.

Things change. Things cycle as they change. The emotional cycle moves from optimism to euphoria to hope to despair, to optimism, etc. etc. much like the rotating of the wheels of a car. Consider what Willa Cather wrote many years ago relative to the emotional cycle of the market: "There are only two or three human stories, and they go on repeating themselves as fiercely as if they had never happened before." I think that there are only four stages of the emotional cycle that the stock market if not we humans orderly repeat just as fiercely over and over again.

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