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Should I really buy the dip, or will the price fall even further? That is a question that many of you have asked yourself. That is perhaps also why technical or fundamental analysis has been invented, to save us from emotional or irrational decisions.
Douglas once wrote, “Anything can happen… and you don’t need to know what is going to happen next in order to make money.” This profound insight underscores the inherent unpredictability of markets, and yet, seasoned investors recognize patterns—not in price movements alone, but in collective human emotions.
So, the “Wall Street Cheat Sheet” has been created as a pattern of emotions, ranging from disbelief to euphoria and back to disbelief. You can see all the ups and downs an investor can experience – and probably, we’ve all been there. However, the Cheat Sheet does not just remind you that everyone has emotions and that the market can be a rollercoaster. Most importantly, the Cheat Sheet helps us to understand market cycles and can be a valuable tool for our investments. If you could actually figure out what phase the market is in, you can make some significant gains.
Our article will help you precisely understand what emotional investing is, the different phases of the Wall Street Cheat Sheet, and how you can apply it in real-life investing.
The Wall Street Cheat Sheet is a visual guide that illustrates the emotional stages investors go through during a market cycle. It breaks down the phases from disbelief and optimism at the start of a rally, to euphoria at the peak, followed by panic and despair as the market crashes.
By understanding these cycles, you can spot opportunities that most people miss and avoid the traps that many fall into. It’s like having a tool that helps you turn the chaos of the market into a more predictable pattern, guiding you to make smarter moves with your investments.
To be honest, we are big fans of investing history as it makes us understand that the things that are happening right now have, in some way, already happened before. As the saying goes, history does not repeat itself but rhymes. What can we take from that? Emotions have always ruled the markets and will continue to rule them.
Take, for instance, the past optimism surrounding the German economy around the 1920s. Many believed it was the ideal place to invest, anticipating that Germany was bound to recover and, thus, their investments would grow. As Keynes noted:
“[From those] in the streets of the capital…[to] barber’s assistants in the remotest townships of Spain and South America…the argument has been the same…Germany is a great and strong country; someday she will recover; when that happens, the mark will recover also, which will bring a very large profit.”
Unfortunately, as we all know, Germany was not able to recover in the way that everybody expected, and most people lost their money with this investment as soon as inflation went through the roof and the German mark collapsed against the USD.
Source: Big Debt Crisis by Ray Dalio
In “Margin of Safety”, Seth Klarman shares a tale about sardine trading in Monterey, California. When sardines vanished from the waters, their can prices skyrocketed due to high demand from traders. Once, a buyer opened a can to eat and got sick. As this trader complained, he was told, “You don’t understand. These are not eating sardines, they are trading sardines.”
Klarman then goes on and compares traders in his years, which was around the 1990s, to these sardines traders, saying that many participants in the financial markets, knowingly or unknowingly, have become speculators.
“They may not even realize that they are playing a “greater-fool game,” buying over-valued securities and expecting—hoping—to find someone, a greater fool, to buy from them at a still higher price.”
So, as you can see, this pattern has happened repeatedly, with a recent one in 2021. The cryptocurrency bull market provides a contemporary example. With soaring prices and a surge in new investors, the market was rife with optimism. All of this was also coupled with the crazy story of GameStop and WallStreetbets investors, creating a collective enthusiasm.
Obviously, for those who understand markets and cycles, it was easy to spot the bubble, and they could profit a lot from it. However, for most, especially for those who do not understand these dynamics, it was a disaster.
Long-standing investors, who have been at market lows before, often view downturns as temporary setbacks. But for newcomers, a market dip can be disconcerting. They might not be prepared for the rollercoaster of emotions and might make rash decisions out of fear or panic.
Highlighting the unpredictability of emotional investing is the story of Vitalik Buterin. His initial $25,000 investment in meme cryptocurrencies like Dogecoin and Shiba Inu eventually earned him millions. Yet, on the flip side, many individuals who bought into the NFT (Non-Fungible Token) trend at its peak were later disillusioned. Some were scammed, while others watched the value of their NFTs dwindle dramatically.
In essence, while emotions are an integral part of our decision-making process, it’s crucial to recognize when they start overshadowing rational judgment in the realm of investments. Emotional investing can lead to remarkable gains and significant losses, whether driven by hope, fear, or a herd mentality.
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In this section, we will go through all of the market cycles one by one – explaining the stage, characteristics, sentiment, indicators and a hypothetical example. Why do we take Tesla? Well, because in real life, Tesla actually went from being one of the most shorted stocks ever to having a P/E ratio of over 1000 and then back down again. So, it is a highly volatile stock and certainly showed almost all the phases of the Wall St. Cheat Sheet throughout its history. Keep in mind, though, that this is a hypothetical example to show a general case. A real-life example of Tesla with correct stock prices will be shown in our next chapter on “How to Apply the Cheat Sheet in Real-Life Investing”.
Imagine it’s the early days of Tesla. You see a stock price hovering around the modest $30 mark. The automotive world is murmuring about how electric vehicles are just a fad. Many think Tesla’s destined to be another blip in the vast history of failed auto start-ups. But then, you notice a few astute investors, those with an eye for potential, starting to buy. Maybe they see something others don’t?
Characteristics: Fresh from a bear market, pessimism is rampant.
Investor Sentiment: Investors are wary. They recall the previous trend’s pains.
Market Indicators: Low trading volume, undervalued metrics.
Example: Tesla in its early days, with a share price around $30, battling skepticism.
Fast forward a bit. Tesla’s share price starts to creep up, hitting $70, then $100. You witness their cars gaining traction, both on roads and in conversations. Those once-dismissed electric vehicles are now turning heads. You think, “Could there be a future in this?”
Characteristics: Signs of recovery. First positive movements after a downturn.
Investor Sentiment: A mixture of optimism and caution.
Market Indicators: Gradual increase in trading volume and price.
Example: Tesla’s share price hits the $100 mark after the successful Model S launch.
With the launch of every new model, from the Model S to the Model X, you see Tesla stock climbing. It’s hitting $200, and the general sentiment is shifting. You sense an upward trend and feel like now might be a good time to jump in. Especially in the common sense of the word we can actually say that most of the tinveoers who are here and there do not need to me
Characteristics: Steady growth and market acceptance.
Investor Sentiment: Increasing confidence in the asset’s future.
Market Indicators: Sustained price gains, bullish news articles.
Example: Tesla’s Model X launch, with the stock climbing to around $200.
Tesla is no longer just a car company; it’s a phenomenon. As the stock price dances around $300, you’re increasingly convinced of Elon Musk’s vision. Tesla’s technological advancements and Musk’s promises about the future of transport bolster your faith.
Characteristics: Investors see the upward trend as the new norm.
Investor Sentiment: Broad market consensus that the asset is a good buy.
Market Indicators: Strong financial metrics, analyst upgrades.
Example: Tesla hits $300, fueled by expanding production and technological advancements.
The media’s all over Tesla. From thrilling Cybertruck reveals to SpaceX tie-ins, Tesla is everywhere. You see the stock price skyrocket to around $900, and there’s a universal buzz. Missing out feels unthinkable. The adrenaline’s real.
Characteristics: Rapid price appreciation. Media hype.
Investor Sentiment: Overwhelming excitement, almost manic behavior.
Market Indicators: Parabolic price move, heavy trading volumes.
Example: Tesla’s stock rockets to $900 post the Cybertruck announcement.
Here comes the peak. Tesla’s stock, defying all odds, touches the $2,000 mark pre-split. The euphoria is palpable. Everyone’s talking about it, and you feel like you’re riding a wave that’s destined for even greater heights.
Characteristics: Peak market conditions. Irrational exuberance.
Investor Sentiment: Universal belief that prices can only go up.
Market Indicators: Extreme overvaluation, incessant media coverage.
Example: Tesla’s pre-split peak at $2,000, with Elon’s ambitious visions for the future.
But then, a few headlines cause ripples of doubt. Production challenges, executive turnovers, tweets from Musk that raise eyebrows. The stock dips to $1,500. However, you’re still optimistic, thinking, “It’s Tesla; it’ll bounce back.”
Characteristics: Initial signs of a slowdown.
Investor Sentiment: “This is just a dip. It’ll recover.”
Market Indicators: Reduced trading volume, beginning of a downtrend.
Example: Tesla dips to $1,500 amidst reports of production challenges and executive reshuffles.
The ripples turn into waves. The stock drops further, down to $1,200. Those once optimistic discussions are now dominated by concerns about competition, regulatory pressures, and more. You start to feel uneasy.
Characteristics: Decreasing prices and increasing doubt.
Investor Sentiment: Worries start creeping in, but most remain hopeful.
Market Indicators: Increased volatility, bearish news.
Example: Tesla’s drop to $1,200 amid concerns about increased competition.
Despite negative news, you hold firm in your belief. The stock’s at $1,000, but you’re sure it’s just a temporary setback. After all, Tesla’s faced challenges before and emerged stronger, right?
Characteristics: Refusal to accept that a downturn is happening.
Investor Sentiment: “This is just temporary. It’ll bounce back.”
Market Indicators: Falling price with occasional upticks.
Example: Tesla lingers at $1,000 despite a string of bad news.
The stock nosedives to $700. You’re now amidst a sea of panicking investors, all trying to decide the next move. It’s a mad scramble. The dream seems to be unraveling.
Characteristics: Rapid decline, almost free-fall conditions.
Investor Sentiment: Widespread fear. A rush to exit.
Market Indicators: High trading volumes at significantly lowered prices.
Example: Tesla crashes to $700, causing a frenzied market reaction.
You’ve reached a point of resignation. With the stock lingering around $600, you start to believe that maybe the naysayers were right. You contemplate exiting, cutting losses, and moving on.
Characteristics: Investors give up any previous gains.
Investor Sentiment: Resignation. A belief that the asset may never recover.
Market Indicators: Low prices, negative news cycle.
Example: Tesla’s stock, now at $600, sees many investors cashing out.
“Why didn’t I see this coming? Why did I trust this so blindly?” You, along with many others, missed warning signs and wonder why you were so caught up in the Tesla whirlwind.
Characteristics: Blaming external factors for losses.
Investor Sentiment: Regret and frustration. Seeking scapegoats.
Market Indicators: Prolonged downturn, widespread negativity.
Example: Investors rue Tesla’s high of $2,000, now feeling burned.
With Tesla shares at a somber $500, the energy is drained. The once-luminous dream feels distant. You’re left pondering what went wrong.
Characteristics: The lowest point, both in terms of price and sentiment.
Investor Sentiment: A general feeling of despair.
Market Indicators: Rock-bottom prices, muted trading volumes.
Example: Tesla’s shares slump to $500, and the dream seems distant.
But wait, there’s movement again. The stock’s nudging up to $550. Yet, after everything, you’re skeptical. “Is this a genuine rebound or just a momentary blip?” Only time will tell.
Characteristics: Signs of stabilization, but skepticism remains.
Investor Sentiment: Doubtful about any new growth.
Market Indicators: Slight upticks in price and volume.
Example: Tesla nudges up to $550, but the market remains wary.
Now that we have shown you the Wall St. Cheat Sheet in-depth, we will continue and actually show you how to apply it in real life. How can we spot a bubble or the bottom of the market?
To understand how most markets work in general, let us borrow the concept of the helix model. The market does not just produce profits and only go up. The market goes in cycles, changing between boom and bust. However, over the long run, it trends upwards, but within the trajectory are many ups and downs, so a helical progress model is a better visualization. Similar to the Wallstreet Cheat Sheet, it is one cycle within that helix that tends to go upward over time.
It shows us that even though market emotions repeat, they do so in fresh contexts each time. Take the S&P500, for instance. Over the long run, it trends upwards, but within that trajectory are numerous cycles of bear and bull markets.
Unfortunately, understanding these emotional phases is just half the battle. Identifying which stage the market is currently in can provide a significant edge in investment decisions.
For that reason, we have three strategies for you that can help you to pinpoint which stages you are in:
Ray Dalio, founder of the world’s largest hedge fund, Bridgewater Associates, has devised a comprehensive “Bubble Indicator.” It’s a framework that examines several aspects of asset pricing to determine if an asset is in a bubble. For example, in their latest research, they have almost perfectly predicted that emerging tech stocks were in a bubble and overvalued in 2021.
As you can see from the chart above, the main factors Dalio’s indicator considers include:
But how could you recreate this analysis on your own? Let us show you how to quickly assess if a bubble might be happening with a real-life example of the Tesla Stock.
First, let us look at Tesla’s price-to-earnings (P/E) ratio throughout 2020 and 2021. You can clearly see a surge in (P/E) ratio starting in 2020 in the chart below. The stock price continued to go higher, though, and investors just disregarded an immensely high PE ratio of 1120!
Even though a high P/E ratio does not always mean that the stock is overvalued, such a quick uptick can give you a good indication that a bubble might be brewing, especially when no new developments have been done within that time. Stage: Thrill/Euphoria
As already mentioned above, even though it seemed like the stock was clearly overvalued, the price just continued to go up. People simply did not care. At some point Teslas market capitalization surpassed all other car brands combined, while their deliveries were just a tiny portion of it.
The reason for that was that many bullish investors and analysts flipped and contended that Tesla’s potential wasn’t confined to the automobile sector; it was an evolving tech and energy behemoth. So, this anticipation was priced into the stock’s valuation. Even though these high hopes might be rewarded in the future, the stock price would have to rely on constant hype and continuous belief – possible or not – only time will tell. Stage: Belief/Thrill/Euphoria
Many new investors, especially on trading apps like Robinhood, started buying Tesla stock quickly. In fact, Robinhood’s user count grew a lot during these two years, suggesting a lot of fresh faces were diving into the stock market, often without deep research into Tesla’s fundamentals. Whenever that many new investors enter the market, it is a good indication that we might be in a bubble and euphoria phase. Stage: Thrill/Euphoria
Tesla’s narrative in 2020-2021 was a media magnet. Coupled with CEO Elon Musk’s pronounced media presence, this led to pervasive bullish sentiment. Every major financial news outlet regularly spotlighted Tesla. Notably, in May 2020, Elon Musk himself tweeted that he felt Tesla’s stock price was “too high.” Stage: Thrill/Euphoria going on to Complacency.
Finally, interest rates and high leverage are very important indicators. Especially when interest rates are at historic lows, the cost to borrow capital is basically 0. In these times, investors are bullish and take on more risk, using leverage to buy stocks and other assets as the market usually rips to new highs. As you can see, this was the case between 2020 to 2022. So, this is also a clear bubble indicator.
Summing up our analysis, we can almost clearly see that for all the questions we can answer the Tesla Stock could very well be trading in a bubble environment. Within the context of the Wall Street Cheat Sheet, we would say that throughout 2020 and 2021, Tesla seemed to move through the stages of Belief, Thrill, and Euphoria, eventually shifting towards Complacency.
However, identifying bubbles as they unfold is challenging. In hindsight, some argue Tesla was in a bubble, while others think its high valuation was justified given its future growth prospects.
Ultimately, it is your own decision as an investor, and the Wall Street Cheat Sheet should just help you to understand where you are in the cycle. As you are probably going through stages of Belief, Thrill and Euphoria, it might be good not to buy new shares or even scale out a bit of the positions. Sell a part of your holdings to new “foolish” entrants and perhaps even take a contrarian position and short the market. Just never forget the wise words of Peter Lynch:
“Far more money has been lost by investors trying to anticipate corrections than lost in the corrections themselves.”
As traders, mastering our emotions and sticking to our trading plan is crucial. As Benjamin Graham, the godfather of value investing, said:
“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”
Benjamin Graham
It’s the difference between growing as a trader or ending up burnt. Emotion and psychology are significant pitfalls, leading to holding onto losing positions and refusing to exit winning ones. We’ve all been there, watching that price tick upward and thinking it will go on forever. But experience is the best guide, and recognizing and avoiding emotional trading is key to long-term success. Explore our in-depth article on “Trading Psychology” for a wealth of knowledge. We go into much more detail there to give advice on how to manage your emotions, develop discipline, and fine-tune your risk management to achieve better results in your trading endeavours.
Not relying on emotions but trusting the data can benefit you enormously. Here is a great example of emotions vs. data. Jarvis Labs has created a great study that compares various simple strategies that buy and sell according to the “Fear and Greed” Index. Fear and Greed Index helps you gauge market sentiment, letting you know if traders are too fearful or too greedy.
In terms of how the index is broken down, it is seen in the table below.
The study concludes that buying when the Fear and Greed Index is below 10, which occurred only 14 times between 2018 and 2022. As you can see, a reading below 10 is extremely rare. And a reading between 20–30 is the most frequent.
Moreover, this strategy that simply relies on trading the emotions of the market gives you an amazing sharpe ratio of 8:
“What you may also notice is the first strategy, which is the short-term strategy (buying below Fear and Greed Index 10 and selling above 35) performed the best with 14.6% returns annually on average. And a cumulative return at 133.4%. It also has the lowest max drawdown risk at -25.3%.”
Finally, Peter Lynch often spoke about a quirky, anecdotal method he used to gauge market sentiment in any market and potential bubbles: cocktail party theory.
“If the professional economists can’t predict economies and professional forecasters can’t predict markets, then what chance does the amateur investor have? You know the answer already, which brings me to my own ‘cocktail party’ theory of market forecasting, developed over the years of standing in the middle of living rooms, near punch bowls, listening to what the nearest ten people said about stocks.”
Markets, in essence, are cyclical. They go up, they go down, and then they do it all over again. However, what makes them fascinating is the human emotion that often drives these movements. Today’s superstar stock could be tomorrow’s relic, and vice versa. And while we’d all love to believe we’re the calm, collected passengers simply enjoying the view, the truth is many of us are clutching the safety bar, driven by a potent cocktail of greed, fear, and FOMO.
“The intelligent investor is a realist who sells to optimists and buys from pessimists.”
Benjamin Graham
So, use the Wall Street Cheat Sheet in your arsenal to help you make an unbiased decision about the market. Because, as fun, as it is to chat to people about markets at cocktail parties (until they all start doing it and you know something’s up), it’s even better to have a toolkit that lets you be just a bit less emotional and potentially ahead of the game.
Disclaimer: All investments involve risk, and the past performance of a security, industry, sector, market, financial product, trading strategy, or individual’s trading does not guarantee future results or returns. Investors are fully responsible for any investment decisions they make. Such decisions should be based solely on an evaluation of their financial circumstances, investment objectives, risk tolerance, and liquidity needs. This post does not constitute investment advice.
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