This Markets in a Minute Chart is available as a poster.

The Psychological Pitfalls of a Market Cycle

When making investment decisions, investors have a wide variety of tools at their disposal.

For example, fundamental analysis can be used to estimate a stock’s intrinsic value. Technical analysis, on the other hand, requires an investor to analyze price movements to identify trends.

While these tools can form the basis of a sound investment thesis, their effectiveness is limited by one’s emotions. In today’s Markets in a Minute chart from New York Life Investments, we illustrate how sentiment can get in the way of rational decision making.

The Mentality of the Herd

Allowing emotions to dictate decisions is a common mistake made by many investors, yet they may not even realize it.

Herd mentality, which refers to an individual’s tendency to be influenced by his or her peers, often leads to heightened emotions and less rational decision making. In the context of investing, this tendency becomes particularly troublesome—market developments can be sensationalized in the media, by online blogs, or through word-of-mouth.

Mapping the Sentiment Cycle

Similar to how markets move in a series of patterns and cycles, the behavior of the investor herd tends to follow a continuous “sentiment cycle.”

1. Market Recovery
Today’s chart begins at the recovery stage of a market cycle, and assumes that emotional investors have recently suffered losses.

Although a support level has been clearly established, the herd is likely too afraid to act. Their fear of making another mistake causes them to miss the optimal window to re-enter the market.

2. Market Peak
Only after prices have substantially risen does the herd begin to take notice. Many of these investors will experience the fear of missing out (FOMO), and overzealously begin buying. Valuations at this point are likely no longer attractive.

3. Market Decline
What comes up must come down, and prices eventually peak as demand weakens. Investors who become too emotionally attached can find it difficult to cut their losses early.

4. Market Trough
By this point, the sentiment cycle has run a full course. Investors who followed the herd have likely sold at a loss, and will be reluctant to re-enter the market again.

Navigating Rough Waters

Investors are prone to falling into the sentiment cycle at any time, but especially when things get rough. So-called black swan events, such as the COVID-19 pandemic, can bring volatility to markets on short notice. In these situations, it’s common for investors to flock to safe-haven assets.

Since COVID-19 was classified as a global pandemic, money market funds have been in extremely high demand:

While this dramatic shift does have its merits—equity markets have seen deep selloffs—it may be a tad drastic. Governments around the world are making serious commitments to providing economic stimulus. In the U.S., the CARES Act amounts to a massive $2 trillion, and provides direct payments to families as well as support for both the private and public sector.

Keeping a Clear Mind

Now that we’ve outlined the psychological pitfalls of a market cycle, what can one do to break away from the herd?

A good start is becoming aware of the cognitive biases we commonly exhibit when investing. These biases can be linked to many of the emotions outlined in today’s chart. Finally, maintaining a growth mindset and learning from our past mistakes can also help us make better decisions in the future.

This Markets in a Minute chart is available as a poster.

Black Swans: Short-term Crisis, Long-term Opportunity

Few investors could have predicted that a viral outbreak would end the longest-running bull market in U.S. history. Now, the COVID-19 pandemic has pushed stocks far into bear market territory. From its peak on February 19th, the S&P 500 has fallen almost 30%.

While this volatility can cause investors to panic, it’s helpful to keep a long-term perspective. Black swan events, which are defined as rare and unexpected events with severe consequences, have come and gone throughout history. In today’s Markets in a Minute chart from New York Life Investments, we explore the sell-off size and recovery length for some of these events.

Wars, Viruses, and Excessive Valuations

With sell-offs ranging from -5% to -50%, black swan events have all impacted the S&P 500 differently. Here’s a look at select events over the last half-century:

* Figure as of market close on March 18, 2020. The sell-off measures from the market high to the market low.

While the declines can be severe, most have been short-lived. Markets typically returned to previous peak levels in no more than a couple of months. The Oil Embargo, Black Monday, and the Global Financial Crisis are notable outliers, with the recovery spanning a year or more.

After Black Monday, the Federal Reserve reaffirmed its readiness to provide liquidity, and the market recovered in about 400 trading days. Both the 1973 Oil Embargo and 2007 Global Financial Crisis led to U.S. recessions, lengthening the recovery over multiple years.

COVID-19: How Long Will it Last?

It’s difficult to predict how long COVID-19 will impact markets, as its societal and financial disruption is unprecedented. In fact, the S&P 500 reached a bear market in just 16 days, the fastest time period on record.

Some Wall Street strategists believe that the market will only begin to recover when COVID-19’s daily infection rate peaks. In the meantime, governments have begun announcing rate cuts and fiscal stimulus in order to help stabilize the economy.

Considering the high levels of uncertainty, what should investors do?

Buy on Fear, Sell on Greed?

Legendary investor Warren Buffet is a big proponent of this strategy. When others are greedy—typically when prices are boiling over—assets may be overpriced. On the flipside, there may be good buying opportunities when others are fearful.

Most importantly, investors need to remain disciplined with their investment process throughout the volatility. History has shown that markets will eventually recover, and may reward patient investors.