Tuesday, 10 January 2012

cycle of market emotions

The 'Cycle of Market Emotions' is one of the most important road-maps for investors as share prices move through periods of boom and bust, of rise and fall, and of calm and volatility.
The curving line represents the cycle of actual share prices and the smaller circles characterise the investor sentiment, which typically occurs along that path. Traditional market wisdom suggests that sharemarkets:

'Climb a wall of worry', with prices rising as fears associated with a recent crisis are gradually shed over time.
'Peak in euphoria' as investors fully commit to a collective belief that equities offer an uninterrupted rosy future for as far as the eye can see. "The view's best at the top."
'Fall on hope' as initial falls are greeted first as a buying opportunity, and next with disbelief and with denial.
'Bottom in despair' as the most stubborn believers capitulate and as the final losses are crystallised.

At turning points in the sharemarket, fundamentals such as earnings and employment growth are usually changing more dramatically than sentiment is changing.
As the market peaks and begins to plunge, investors remain wedded to their view (which has been cemented by the experience of a long prior bull market) that "nothing has fundamentally changed" – even as corporate earnings begin to collapse.
In the same manner, as the market bottoms and begins to rise, sentiment is slow to adjust to the new changed reality. For example, the bounce in global sharemarkets in mid-2009 was greeted with disbelief, even as underlying conditions were taking a turn for the better.
However, in uptrends and downtrends – and Russell's view is that we are now in a fragile uptrend – the opposite applies. That is, sentiment is usually fluctuating more dramatically than the fundamentals are changing. Hope, relief and optimism may indeed characterise a recovery phase in the sharemarket – but with investors being inundated by recurring bouts of bad news in the wake of the previous crisis, there will be gut-wrenching days and weeks when hope and optimism are beset by dark fears.
Current volatile conditions are what climbing the 'Wall of Worry' usually looks like. At this juncture, global share prices are off 20% from their post Financial Crisis highs, in a downdraught of doubt. But those prices are still up 60% from their crisis lows. Meanwhile, the fundamentals of earnings and employment growth continue to grind – slowly and fragilely – higher.

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