The importance of recognising where we are in the market emotions cycle can and should never be understated.
In bull markets, investors ride the markets as if nothing can stop them, but when matters turn for the worse they head for the hills.
In the case of individual shares, investors are backing the winners and sell under-performing shares only to see their fortunes dwindle when the tide turns against them as the winners suddenly turn out to be the losers.
Investor emotions are well-documented by market observers.
In the early stages of a bull market (remember that it has just emerged from a bear market), scepticism is rife among investors.
Despite rising prices, the investors suffer from depression and apathy and indifference, leading to a reluctance to commit funds to the market. The follow-through of rising equity prices leads to optimism as investors see returns for the risk of investing and are thrilled when their expectations are met and even exceeded.
Their optimism reaches a point where the investors are euphoric that the above-average returns will continue forever. This feeling good stage is the stage when investors face maximum financial risk.
Turning points in the markets are mostly event-driven such as Black Swans. The anxiety caused by the events makes investors unsure as to where the market is heading and they opt to rather sit it out.
However, when the price declines continue, the denial quickly turns into fear as investors start to panic. Some capitulate and withdraw from the market while others become despondent and ask themselves how they could be so wrong. That is the stage when investors are at the point of maximum financial opportunity.
There are times when some Black Swans or events cause anxiety but actions by central banks may alleviate fears of investors and create the environment for investors to expect positive returns after which the thrill and euphoria stages follow as the bull market resumes.
Where are we in the market emotions cycle right now?
Although highly subjective, an overlay of the market emotions cycle on the MSCI World Index from 2003 provides insight.
The stages of the market emotions cycle during the bull market after the pop of the dotcom bubble and 9/11 events speak for itself. First, the reluctance to commit funds, then optimism, excitement, thrill and euphoria.
The development of the sub-prime crisis at the end of 2007 turned the stock market, leading to anxiety, but the market bounced back as investors saw it as a temporary setback (the denial stage).
The global liquidity crisis, led by the demise of Lehman Brothers, scared investors as emotions turned from fear to capitulation and despondency. Although the market turned for the better afterwards, an initial cautious behaviour of investors was apparent and especially due to the debt crisis in Greece in 2010 and the euro debt crisis in the following year.
Optimism returned, however, the ensuing euphoria was short-lived due to the meltdown in oil prices and Chinese assets.
The initial stages of Brexit caused anxiety but central bank actions managed to calm the markets.
At this stage, in light of the rich valuations and low volatilities in the markets, it is evident that we are in the euphoria stage in the market emotions cycle.
It is not to say that the market cannot run further as the euphoria stage may last for months and even longer.
That said, the following quote by Russell Investments is relevant: “Because emotions can be such a threat to an investor’s financial health, it is important to be aware of them.
"This awareness can then protect you from the negative consequences of impulsive and irrational reactions to these emotions.”
Ryk de Klerk was a co-founder of PlexCrown Fund Ratings and is currently a consultant for PlexCrown Fund Ratings.