Wall Street Cheat Sheet: Mastering Fear and Greed for Successful Investing

Introduction

André Kostolany introduced the "Kostolany's Egg" theory to explain market cycles. He divided bull and bear markets into six phases and recommended taking the contrarian approach instead of following the crowd. The key is to roughly identify the right moment to invest, which corresponds to the lower third (B3~A1) of the egg as shown below.

Source: medium.com

However, in reality, stock prices never rise or fall smoothly like the surface of Kostolany's Egg. Stock prices always move in a zigzag pattern, which usually makes it hard to determine which phase of the bull or bear markets we are currently in.

The "Wall Street Cheat Sheet" is a visual tool that aims to explain these zigzag movements of the overall market or individual stock prices more clearly by showing the emotional stages investors experience during market cycles. Let’s take a look at what this cheat sheet looks like.

Wall Street Cheat Sheet

Source: www.wallstcheatsheet.com (Note: the site is no longer active)

The "Wall Street Cheat Sheet" visually represents market cycles and the emotions investors experience throughout these cycles. It illustrates the collective emotional patterns of investors, from disbelief to euphoria and back to disbelief. You can use this as a reference to understand the typical  cycle of market bubbles.

Psychological Phases in the Wall Street Cheat Sheet

Below are brief explanations of each psychological phase from the Wall Street Cheat Sheet.

1) Disbelief: This is the typical reaction of investors at the start of a new bull market after a bear market. Most investors are skeptical and watch from the sidelines, doubting the rally will last.

2) Hope: After an initial rise, the market enters a correction, but early investors remain hopeful. Investors who missed the early gains begin to enter the market slowly.

3) Optimism: As market momentum strengthens again, more investors become optimistic that the upward trend will continue. Media attention begins to increase.

4) Belief: Prices surge and then stabilize. Investors gain strong confidence and start going all in. Media coverage increases, and more people start talking about the market.

5) Thrill: The upward trend resumes. Investors feel that they’ve got to tell everyone to buy this. Indeed, most investors, driven by FOMO (Fear of Missing Out), jump in to buy.

6) Euphoria: Prices reach extreme levels, but bubble warnings are ignored. Investors start believing they are investment geniuses, dreaming of becoming rich. The "greater fool theory" is in play, where investors think there will always be someone willing to buy at a higher price.

7) Complacency: The upward trend stops, and a correction occurs, but soon a small rally gives the illusion that the trend will continue. Investors believe it’s just a temporary correction.

8) Anxiety: Prices continue to drop. Investors start feeling anxious while hoping for a rebound.

9) Denial: Prices fluctuate, and many investors experience significant losses but refuse to accept the downward trend, still believing the market will bounce back.

10) Panic: Prices plunge, and most investors are gripped by fear, believing they must sell immediately.

11) Capitulation: Most investors suffer heavy losses and sell off their entire holdings.

12) Anger: After prices plummet and stabilize, investors feel betrayed and angry. They believe the situation is unfair and that someone should be held accountable.

13) Depression: As prices stabilize and then begin to fall again, many investors experience feelings of depression and despair.

1) Disbelief: After being extremely undervalued, prices begin to rise again, but most investors are skeptical and observe from the sidelines, doubting the rally will last.

The Dot-Com Bubble of 2000

The below chart applies the "Wall Street Cheat Sheet" to the actual changes in the S&P 500 index during the 2000 dot-com bubble. It aligns well when we look at how investors' emotions shifted.

Source: https://www.liberatedstocktrader.com/wall-street-cheat-sheet

In general, the Wall Street Cheat Sheet can be applied to any situation where a bubble forms and bursts—whether it’s an individual stock (e.g., GameStop), a particular set of companies (e.g., early dot-com companies), or the certain market (e.g., U.S. subprime loan market before the global financial crisis).

Understanding Current Market Sentiment

Just as it's difficult to find a direction in the middle of a forest, it's not easy to gauge the current phase of the market. One tool developed to objectively assess market sentiment is CNN’s Fear & Greed Index.

In simple terms, CNN’s Fear & Greed Index is calculated based on seven factors: (1) stock price momentum, (2) stock price strength, (3) stock price breadth, (4) put/call options, (5) demand for junk bonds, (6) market volatility, and (7) demand for safe haven assets.

Source: https://edition.cnn.com/markets/fear-and-greed, 2024/10/15

CNN’s Fear & Greed Index classifies market sentiment into five stages: Extreme Greed, Greed, Neutral, Fear, and Extreme Fear. As of October 15, 2024, the sentiment in the U.S. stock market is on the higher side of Greed, according to the index.

Now, you might be curious about how sentiment has been changing recently - whether it's becoming more greedy or less. The graph below shows the trend of sentiment changes over the past 12 months. Since early August this year, sentiment has risen significantly. When the index falls below 25, it indicates Extreme Fear, and when it exceeds 75, it signals Extreme Greed. As of October 15, 2024, the score is 70.

Source: https://edition.cnn.com/markets/fear-and-greed, 2024/10/15

One drawback of CNN’s Fear & Greed Index is that while it's useful for tracking market sentiment changes over several months, it may not be very helpful for identifying the current position in long-term cycles that span years. Stock market experts often have sharply divided opinions. Ultimately, investors themselves must assess where the current financial market cycle stands. The Wall Street Cheat Sheet, the CNN's Fear & Greed Index, and the expert opinions can only provide some guidance to help you form your own opinion.

How to Use the Cheat Sheet

André Kostolany emphasized that the role of psychology in the stock market cannot be overstated. He added that in the short and medium term, psychology determines 90% of the stock market. In other words, without understanding investor sentiment, you’re only seeing 10% of the trees while missing the forest, i.e. big picture in your investments.

In my opinion, the Wall Street Cheat Sheet can serve as:

• A reminder that market sentiment follows cyclical patterns, repeating over time.
• A tool for analyzing the relationship between asset prices and investor sentiment, giving clues about which stage the market might be in.
• Most importantly, a way for investors to reflect on their own emotions, recognize emotional pitfalls such as euphoria, denial, or panic, and help overcome these emotional errors.

Of course, the Wall Street Cheat Sheet is hardly a perfect guide and it isn't always accurate, but I believe it can still be a useful tool for investing. Warren Buffett’s mentor, and the father of security analysis, Benjamin Graham, once said, "The most important thing in investing is to eliminate emotion and think rationally when making investment decisions." Just as understanding market sentiment is crucial, so too is ensuring that investors themselves remain rational and avoid being swept away by the market mood. By regularly referring to the emotional stages outlined in the Wall Street Cheat Sheet, you can develop the habit of checking whether you are in an irrational emotional state, which will ultimately aid your success in investing.

Thanks for reading. Wish you grow rich slowly and surely!

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