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1. What is Market Sentiment?
In reality, many people believe that emotions are the primary drivers behind financial market fluctuations, and overall investor sentiment is what creates psychological market cycles.
In summary, market sentiment refers to the general feeling of investors and traders about the price movement of an asset. When market sentiment is positive and prices are continuously rising, the market tends to be bullish (bull market). Conversely, when prices are consistently falling, it is referred to as a bear market.
Thus, market sentiment is shaped by the views and emotions of all traders and investors in the financial market. In other words, it represents the average feeling of market participants.
However, just like with any group, no single opinion can completely dominate. According to market sentiment theories, the price of an asset tends to fluctuate in response to the general sentiment of the market, which is always changing; otherwise, it would be very difficult to execute a successful trade.
In practice, when the market is rising, it is likely due to improved attitudes and beliefs among traders. Positive market sentiment increases demand and reduces supply. In turn, increased demand can create a stronger signal. Similarly, when the market is in decline, it leads to negative sentiment, reducing demand and increasing available supply.
2. How Emotions Change During Market Cycles?
2.1 Bullish Trend
All markets go through cycles of expansion and contraction. During an expansion phase (bull market), the market becomes very optimistic, confident, and greedy. Typically, these positive emotions lead to a surge in buying activity.
The cyclical effect is quite common during market cycles. For instance, if market sentiment becomes more positive as prices rise, the sentiment will continue to improve and push the market higher.
In some cases, the market may move sideways for a period as assets are gradually sold. This phase is known as the distribution phase. However, some cycles do not have a clear distribution phase, and the trend may begin to decline immediately after reaching a peak.
2.2 Bearish Trend
When the market starts to turn, the initial excitement can quickly transform into a quiet resignation, as many traders refuse to believe that the uptrend has ended. As prices continue to fall, market sentiment swiftly turns negative, overwhelmed by anxiety, denial, and panic.
As prices drop further, stronger selling waves occur. At this point, fear and panic often lead to what is known as market capitulation (when investors abandon and sell their assets close to a local bottom).
Eventually, the downtrend will halt as volatility decreases and the market stabilizes. Typically, the market undergoes a period of sideways movement before feelings of hope and optimism begin to resurface. This sideways period is also known as the accumulation phase.
3. How Do Investors Use Market Sentiment?
If the theory of market sentiment is valid, understanding it can help traders enter and exit the market at more favorable times. The general market sentiment has an inverse effect: the highest financial opportunity (for buyers) often arises when most people are despairing and the market is very weak. Conversely, the highest financial risk often appears when a large majority of market participants are eager and overly confident.
Therefore, some traders and investors attempt to gauge market sentiment to detect different phases of its psychological cycle. Ideally, they use this information to buy during panic phases (when prices are lower) and sell during peaks in buying enthusiasm. However, identifying these optimal points in practice is not easy.
4. Technical Analysis and Market Sentiment
Looking back at market cycles, anyone can recognize how general sentiment has changed. Analyzing historical data can reveal which actions and decisions could have yielded the highest returns.
However, understanding how the market is changing at the current moment is more challenging, and predicting future trends is even more difficult.
The MACD indicator is an example of a tool that can be used to detect different psychological phases of the market cycle.
5. Market Sentiment and Bitcoin
The Bitcoin market in 2017 is a clear example of how market sentiment affects prices and vice versa. From January to December, Bitcoin rose from around $900 to an all-time high of $20,000. At that time, market sentiment became increasingly positive. Thousands of new investors entered the market, caught up in the excitement of the bull market.
The trend reversal began in late 2017 and early 2018. The market downturn caused significant losses for many latecomers. Even as the downtrend was established, confidence and complacency led many to stubbornly hold on.
A few months later, market sentiment became extremely negative as investor confidence hit an all-time low. FUD (Fear, Uncertainty, Doubt) and panic led many buyers who bought near the peak to sell near the bottom, incurring substantial losses.
6. Conclusion
Most traders and investors agree that sentiment affects prices and market cycles. While the theory of market sentiment cycles is popular, it is not always easy to manage. From the Tulip Mania in the 1600s to the dot-com bubble in the 90s, even seasoned traders struggle to separate their own emotions from the general market sentiment. Investors also face the challenging task of grasping not only market sentiment but also their own emotions and how they impact their decision-making processes.
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