Should you trust market hype? My lessons from market cycle psychology

Market cycle psychology plays a key role in understanding stock trends and investor behavior. In this article, trading expert and analyst Krisada Yoonaisil explores how emotional biases and economic patterns influence market movements, breaking down the key phases of a market cycle and the best investment strategies for each stage.

If you have been following economic and financial news for a while, you may have noticed that events tend to repeat in cycles, whether in the economy or the stock market. These cycles occur due to various factors unique to each cycle but often exhibit similar characteristics.

These recurring patterns have been studied and developed into theories based on psychology, economics, and technical analysis to explain different types of cycles. Each phase of a cycle has its unique characteristics. This article consolidates these common characteristics and explains which assets or industries present opportunities during each phase.

Market cycle theories

Psychology of a market cycle

The first theory is the psychology of a market cycle, which examines how investor emotions and attitudes influence market trends. Cognitive biases shape decision-making, particularly in timing and asset transactions. Positive performance excites investors, while declines lead to disappointment, with emotions driving market reactions.

This theory categorizes the cycle into the following phases:

• Disbelief and reluctance.
• Hope, optimism, and belief.
• Thrill and euphoria.
• Complacency, anxiety, and denial.
• Capitulation, anger, and depression.

Stock market cycles

The second theory relates to stock market cycles. This concept follows a semi-technical perspective on financial market conditions and encompasses trends and patterns in different market or business environments, primarily referencing stock market indices.

Key points of this theory include:

• Market cycles refer to trends or patterns that emerge in different business conditions.
• The time frame of cycles may vary depending on what investors are observing.
• Market cycles generally consist of four distinct phases.
• It is difficult to accurately determine which phase of the market cycle we are in at any given moment.

The stock market cycle is categorized into four phases:

1. Accumulation phase: Investors begin returning to the market.
2. Mark-up phase: Prices start rising.
3. Distribution phase: Investors begin taking profits.
4. Downturn phase: The market starts declining.

Combining the two cycle theories

Accumulation phase: Disbelief, reluctance, hope, optimism, and belief

At this stage, retail investors typically exhibit caution and reluctance to enter the market as stock prices remain at depressed levels. However, early signs of a market reversal begin to emerge. Prevailing news sentiment is overwhelmingly negative, fostering widespread uncertainty and skepticism. The predominant investor mindset is characterized by risk aversion and fear of making erroneous decisions. In contrast, long-term investors with a strategic outlook recognize the potential for recovery and start gradually accumulating positions in anticipation of an upward trend.

Key investment vehicles:

• Stocks: Look for cyclical sectors (e.g., financials, industrials, consumer discretionary) that tend to recover strongly after a market bottom.
• Index funds & ETFs: Market bottoms have historically delivered strong long-term returns.
• Investment-grade corporate bonds: The credit market carries high premiums during negative business cycles, offering strong returns on well-selected corporate bonds.
• Real estate investment trusts (REITs): These often decline sharply during downturns, providing a chance to buy high-quality real estate exposure at discounted prices.

Mark-up phase: Thrill and euphoria

Many investors re-enter the market as positive trends become evident. Bullish market conditions and media promotion support this phase. Traders and investors feel hopeful, confident, and convinced about the market's potential. Asset prices consistently rise, the market stabilizes, and an uptrend emerges. Retail investors increasingly participate in the market during this phase.

Key investment vehicles:

• Stocks: High-growth companies in sectors such as technology, consumer discretionary, and innovative industries (AI, biotech, EVs) tend to outperform in a strong market.
• Small-cap stocks: These often outperform during bull markets due to higher growth potential (e.g., Russell 2000 ETFs).
• Commodities: Broad-based commodities often rise after an economic boom due to inflation and increased demand.

Distribution phase: Complacency, anxiety, and denial

Retail investors continue entering the market in greater numbers, lured by widespread positive news. However, experienced investors start selling their holdings and gradually exit. Asset prices reach new highs, and market valuations, such as the price-to-earnings (P/E) ratio, rise significantly. Buying momentum slows while selling pressure increases.

Key investment vehicles:

Defensive stocks & sectors:

• Consumer staples: Essential goods remain in demand.
• Healthcare: People still need medical care.
• Utilities: Reliable earnings and dividends.

Defensive hedging strategies:

• Inverse ETFs for short-term hedging against market downturns.
• Options strategies (protective puts, covered calls).

Raising cash: Money market funds and short-term treasuries allow investors to buy at lower levels after a correction.

Downturn phase: Capitulation, anger, and depression

When a market crisis begins, many investors find themselves holding stocks at peak prices while asset values decline rapidly. Panic spreads as stock prices drop continuously. Smart investors reduce their portfolios to mitigate risk, whereas retail investors attempt to average down, hoping their assets will eventually rebound.

Key investment vehicles:

• Defensive stocks & sectors: Consumer staples, healthcare, and utilities.
• Government bonds: During economic overheating, inflation rises and leads central banks to raise interest rates. As the economy declines, they lower rates to stabilize growth and prevent a deeper recession.
• Precious metals: Gold and silver hedge against uncertainty, especially in financial markets.
• Cash and money market instruments: Preserve capital during volatile periods.

Key takeaways from market cycle psychology

1. Market cycles repeat over time: Economic and financial trends follow cyclical patterns influenced by investor psychology, economic conditions, and technical factors.
2. Investor emotions drive market movements: Fear, greed, optimism, and panic significantly impact market trends, leading to predictable phases in market cycles.
3. There are distinct phases in a market cycle: The market cycle consists of accumulation, markup, distribution, and downturn phases, each with unique characteristics.
4. Early signs of a market reversal emerge in the accumulation phase: Long-term investors recognize opportunities while retail investors remain skeptical.
5. Euphoria signals a market peak: The mark-up phase sees strong market confidence, media hype, and widespread optimism, often preceding a downturn.
6. Experienced investors take profits during the distribution phase: While retail investors continue buying, professionals start selling as valuations become stretched.
7. Market crashes are driven by panic and capitulation: The downturn phase is marked by fear, widespread selling, and extreme pessimism, often creating long-term buying opportunities.
8. Different asset classes perform better in different phases: Cyclical stocks, defensive sectors, bonds, real estate, and commodities all have ideal entry points based on the market phase.
9. Hedging strategies can protect portfolios in downturns: Defensive stocks, inverse ETFs, options strategies, and cash holdings help mitigate risks during market corrections.
10. Understanding market psychology helps investors make better decisions: Recognizing emotional biases and aligning investment strategies with market cycles leads to smarter and more profitable investing.

Final thoughts

Understanding market cycle psychology and stock market cycles helps investors make better decisions by providing context for price movements and trends. Many investors fall into the trap of reacting emotionally—chasing hype when prices are high and panicking when markets fall. Recognizing these patterns allows for a more strategic approach, whether it's buying undervalued assets during downturns or being cautious when sentiment is overwhelmingly positive. While no one can predict market movements with certainty, studying these cycles can improve long-term decision-making and reduce costly mistakes.

Take a moment to assess where we are in the cycle and how your own biases might be influencing your choices. Are you following the crowd, or are you thinking ahead? Adjust your strategy, stay informed, and be prepared for what comes next. Make your next move with confidence.