As you get comfortable with the world of investing, you’re bound to encounter the term ‘sentiment cycle’. What is this key part of the business cycle, and how does it affect your investment strategy? Let’s take a closer look.
What are the market cycles?
This key concept in behavioural economics refers to the ‘emotional’ aspects of an investment’s lifetime. Speaking broadly, we see both markets and individual stocks go through four key life stages:
- They rise
- They peak
- They fall
- They bottom out
Properly, these are the accumulation, uptrend/mark-up, distribution, and downtrend/mark-down phases of the market.
This process is cyclical. We see a stock that’s a cheap buy with potential. It rises in price. More and more people join in. Inevitably, the stock becomes overpriced, and investors begin to see less value for money and less growth potential. There’s no way it can earn back what people paid for it. Those who bought while the price tag was appealing begin to sell in earnest. It becomes less popular and of less worth until it bottoms out. Rinse and repeat.
This is the natural lifetime of the stock market. In a perfect world, we would always follow the key adage: Buy low, sell high, and we would win on every investment. Yet we are all human, and it is incredibly hard to separate feelings from this natural market process. This is where sentiment cycles begin to play a part in your investment procedure. While a smart investor should always try and leave sentiment out of their decisions, knowing how the sentiment cycle is sitting on your current product is immensely useful.
So what is the investor sentiment cycle?
As with the overall market cycle, sentiment will typically loop back over time. Let’s look at the key stages of the investor sentiment cycle:
- Out of fashion: The news is mostly negative about the product, but it’s giving some indications of ‘hitting rock bottom’ and looking up. Asset prices fell, but the speed of decline is beginning to let up
- Early adoption: The news is near non-existent. Some investors are biting, but it’s off most people’s radar. Asset prices slightly start to rise.
- Participation: Now it’s in the news, especially for retail investors, and there’s obvious reasons to keep buying and talking about it. Asset prices are rising well
- New paradigm: There’s a bull rush on the product, returns are great, and some investors can be lured to sell other assets in favour of this one. The asset price is rising. Typically, this is one of the longest phases.
- Blind faith: Investors aren’t acknowledging there’s a slight decline in prices. The press has gone quiet again, and asset prices are dipping, but people still believe in this class of asset.
- Acknowledgement: There’s still ‘good reason’ to look at this class according to the news, but new investment is low or non-existent. Investors are noticing a falling asset price.
- Acceptance: As prices continue to fall, withdrawals begin and this is no longer seen as a viable asset class.
- Capitulation: As prices rapidly fall once again, people who didn’t sell can see substantial loss, and it’s an ‘understood’ process. Long term outlook for the asset has changed.
At this point, the asset or class cycles back to begin again.
What are sentiment indicators?
So, now you know more about the sentiment cycle, let’s look at sentiment indicators. These are designed to show how specific groups feel about the market (or economy in general) right now. It’s an attempt to quantify sentiment, if you will. It attempts to predict how people’s beliefs and positions will affect the market going ahead.
A lot of things are used to create these sentiment indicators. Is the market bullish or bearish? Are there unusually strong feelings in play? When there’s a peak in sentiment, it’s often a good signal that the market prices could flip soon.
So what can they tell you? Firstly, they give a good grasp of how optimistic or pessimistic people feel about the economy. This can, in turn, indicate how companies and investors may react. Of course, it’s not a precise science. Data is always open to interpretation. It’s wise not to use them as an unbreakable timing signal, but rather one part of your informed decision towards taking action. Nor can they give us a definite ‘when’. It will be up to you to watch for the key turning points in price.
Yet it’s very useful to know what market trends are doing as part of your overall investment strategy.
Sentiment cycle indicators vs technical indicators
While there’s some inevitable overlap, sentiment indicators and technical indicators are different. Sentiment indicators showcase investor beliefs and feelings. Technical indicators are formulas trying to use solid data to manipulate price/volume data to provide a different perspective on your decision.
What is the efficient market hypothesis?
We should probably also mention the efficient market hypothesis. This idea suggests that stocks always trade at their fair value, meaning stocks are never ‘undervalued’ and cannot be ‘inflated’ in price. Meaning you cannot outperform the overall market through timing, and the only way to get high returns is through taking on more risk in investments. It strongly encourages investors to hold a low-cost, passive portfolio they intend to hold and sell, and not attempt to time the market based on matters like sentiment. It’s one of many investment strategies, and which you use will depend on what fits best with your risk tolerance.
As you can see, the sentiment cycle is a key part of any investor’s toolbox. While it’s not the only indicator you will use to help you make smart investment decisions, understanding the sentiment cycle and a stock’s current place within it is key to making good investment decisions.