Wall Street Cheat Sheet: Understanding Market Cycles

A couple of years ago, in 2017, the crypto markets went on an epic bull run. Between January and December 2017, we saw a 20x rise in the price of Bitcoin – and then the market crashed. Then, people shared a Wall Street Cheat Sheet chart.

This type of massive boom-bust scenario, while not typical in the short run, has happened many times in the history of organized capital markets. So many times, in fact, that the generic event has been made into a meme which is the subject of this piece: the so-called “Wall Street Cheat Sheet” (or alternatively “Market Cycle Cheat Sheet”).

Here, we will discuss the Wall Street Cheat Sheet and what we believe it is trying to express, and what you as a trader or investor in crypto – or anything else – can take away from it.

A Market is a Market

It seems clear that crypto has become, for some, an entry point to the larger and more general world of trading-investing. And while all markets have their respective differences and idiosyncrasies, they also have some things in common.

One of the uniting forces common to all markets is emotion: whether it’s the S&P, mortgage-backed securities, or Bitcoin, the dual emotions of caution and anticipation (more commonly put as "fear and greed") — and the emotional spectrum which lies between these two poles — are assumed to dominate the flows of any market.

Perhaps no other image captures the emotional component of trading-investing as concisely as this Wall Street Cheat Sheet, which any intermediate-level market watcher has probably seen. The Bitcoin market alone has seen at least three major market cycles that could be grafted over this general template, depicted below.

(At least) three bubble popsBTC chart by TradingView

The Wall Street Cheat Sheet shows the market cycle of a hypothetical asset bubble bursting, after a so-called "parabolic" price runup. It’s a generic pattern, not taken from any actual chart (that this staff writer is aware of), and thus any asset bubble can fit within the pattern.

That this is not an actual chart, but rather a notional one, is fine because what’s important is not the specific market structures or patterns in the chart, but instead the generalizations about a market’s typical, collective emotional reaction to this kind of price action.

If we distill the Wall Street Cheat Sheet down to its basic message, what it aims to show is the emotions that propel huge, volatile movements in markets, the aforementioned fear and greed.

To be more specific, the emotions depicted on the Wall Street Cheat Sheet are those of the "dumb money", the mostly un-profitable participants in this particular market pattern. After all, we can presume that both successful and unsuccessful traders/investors experience fear and greed on some level. Critically, they do not occur at the same time; and nor should winning traders be overcome by emotions.

Losing traders/investors, whose emotions are depicted here, are always at least one step behind the market's trend. Their emotions are firing always too late. Put another way, they're having the correct emotions at the wrong times: they are scared when they should be greedy, and greedy when they should be scared.

Overwhelmed by what they perceive to be an ironclad trend, these people/entities are trying to enter the market that they falsely perceive as being virtually risk-less.

Market Trends are Complex

In principle, they are doing the right thing. The saying goes that "the trend is your friend", and it is completely accurate. The basis of all trading and to some extent investing is defining trends. Spotting the trends on an array of different timeframes, and being able to jump on them for the ride is what trading is all about. The rest is just details.

However, this saying is packaged with a second, often unmentioned subjunctive clause: "the trend is your friend -- until it's not".

Trends are complicated and multi-dimensional, and not actually that simple to parse accurately and across every timeframe. After all, if it were easy, everyone would do it. And here on the Market Cycle Cheat Sheet, there is visible a classic conceit: an impossibly strong trend that seems like it will never end.

All trends — all, we assume — end, but before they do, they often fake, reverse, zig-zag, go against the technical indicators, zig-zag again, and defy expectations. There is an entire mature, fully elaborated methodology called Elliot Wave Theory dedicated to looking into where the trends are in a market and defining their structures in minute detail; and although its principles are simple enough, it is rather difficult to learn and requires a trained hand to apply.

All of this is to say that, for a novice, it can be difficult to accurately say what the trend is on X timeframe; more to the point here, it is very difficult to say when a trend is ending. Recent examples include the seemingly unending S&P500 bull run, the Tesla bull run, among others. Indeed, the Market Cycle Cheat Sheet could be easily grafted over Tesla’s chart.

In fact, this difficulty in spotting trend-ends is the essence of the foreboding trading maxim "don't try to catch a falling knife", which statement naturally applies to both longs and shorts. The falling knife is an ending trend, and trying to time the trend’s conclusion is, as the saying implies, extremely risky.

Thus, entering a trend which seems very established and sure to continue can be just as tricky as betting against a trend that seems like it should be ending very soon. Any bubble pop that the Wall Street Cheat Sheet can be grafted-over will include many traders who lost big betting on a trend reversal (again, like Tesla shorters recently), and traders who entered believe the trend was safe.

Here we can return to our losing traders, first considered above, who were "doing the right thing". The thing they were doing right was going with the trend, jumping aboard to a clear direction in price movement. This is reflected in the Wall Street Cheat Sheet right about at the Disbelief phase ("Time to get fully invested"), and then at the Thrill phase ("Gotta tell everyone to buy!").

The Right Move at the Wrong Time

These traders/investors are too late to the trend, and presumably not guarding against the danger of reversal at what is likely the end of a trend. They are buying into the trend after the trend has become very obvious to everyone; they are doing the right thing at the wrong time. They should have bought into the trend sooner, when it was first detectable, which takes significant skill, but not so soon that it's just gambling, or catching the falling knife.

The result is what we see on the far side of the asset's collapsing price: complacency, anxiety, denial and panic. These people are sure that they are still invested in what is ultimately an uptrend. Because of greed, they do not see that the trend has likely ended and is reversing.

This makes Complacency portion of the chart perhaps most compelling. We can see a real-life example of this area on the 2018 Bitcoin chart, below.

bitcoin price chart in 2018Source: TradingView

Here, we can see in early January that the unbelievable uptrend was likely over, and a reversal had begun setting in. This was a last chance for any decent trader to sell (better traders had likely been incrementally exiting positions all December), but many held on for a while believing that it was just a speed bump before the next monster bull run.

Ultimately, the key lesson from the Market Cycle Cheat Sheet is the lesson of trends. Knowing what the trend is of a given asset is, in a sense, the only thing that matters in trading.

As in chess, what starts as a simple game becomes almost impossible to answer definitively. Unless you actually control a market — which would be fraudulent — it is impossible to say for sure when a trend is starting or ending.

You can never know beyond any doubt; it is always a risk, and the best response is to make the most educated and informed guess possible while tightly managing risk. When education and experience replace emotion, a trend can be gleaned — most of the time.

Featured image via Pixabay.