"The market has been going up for weeks, should I chase it? Things are getting scary, should I cut my losses?"
These are the questions investors ask every single day. It is because they don’t actually know what the market is doing right now. Not in any structured, reliable way. Most people are reading headlines, checking prices, feeling the mood, and then making decisions based on noise rather than a clear picture of where the market actually stands.
The market moves on how millions of people feel; are they greedy, hopeful, calm, fearful, or desperate? And because so many people participate, those feelings reinforce each other. Hope spreads, panic spreads faster. This is why you see periods where desperation is so dominant that every piece of good news is met with heavy selling, and periods where a ‘no-news’ is rewarded with panic buying. The news, the data didn’t change. The mood did.
Traders have long tried to capture this mass emotion in a single number. The result is a family of tools known as “fear and greed” indicators. They pull news sentiment, investor surveys, portfolio allocation data, and more, all in an attempt to read the crowd’s current psychological state.
The problem is that most of them are inherently subjective. News sentiment relies on how journalists frame the wording. Those filling out survey forms are clouded by emotion and judgment. Even a survey of portfolio weighting must assume that everyone is truthful and fully understands how they fill out the forms.
In our experience, the fear and greed indicators can be useful only when they are at extreme levels, either fear or greed. In between, they are just noise.
Measuring Market Behavior Objectively
The best way to measure market emotion is via the price itself. It is definitely objective and quantifiable, and depending on the formula, can be much less noisy. More importantly, it’s not just emotion we measure, but also behavior.
One might be aware of the adage: Bull markets take the stairs, bear markets take the elevator. A bull market usually happens slowly with contained volatility. On the other hand, a bear market usually happens fast with volatility spikes. This is an oversimplified generalization, but that is the idea.
Using returns and volatility of price, we can separate market behavior into five regimes. Each one is distinguished from the other by its volatility.
We conducted extensive research on 90 assets across various categories (equity, fixed income, currency, commodity, and crypto) from 1997 to 2025. Our research shows that regime classification can separate market behavior with good consistency.
The Despair regime has the most volatility but a good return/risk ratio. This is the time we should be ready to put our cash to work. However, the high volatility usually causes our emotions to cloud our judgment and we lose the opportunity. This regime is also the shortest, lasting only three days on average. The Despair regime is rare, occurring only in 2.5% of market time.
The Anxiety regime is the dangerous one. Not because it gives a rather low return/risk ratio, but because our denial is at its strongest in this stage. In this regime, the market is usually choppy and slowly grinds down.
The Complacency regime makes up the bulk of market time. It is a calm market where nothing seems to happen. While the return/risk ratio is the lowest, this regime is actually good for mean-reversion strategies with tighter bands.
The Optimism regime is the safest one. It gives a high enough return/risk with low volatility. It also makes up a significant portion of the market time. In this regime, momentum plays gain traction, weighting can be bolder.
Euphoria is the regime that brings a good return/risk ratio because its volatility is usually low. This is the result of an extension of the Optimism regime. However, one should be cautious in this regime because it can be succeeded by a sudden bear market. It’s time to take some chips off the table. Remember: “Bull markets take the stairs, bear markets take the elevator.”
The true gem of this regime classification is the fact that they happen sequentially. The market almost always walks according to this sequence: Despair, Anxiety, Complacency, Optimism, Euphoria. It can walk back and forth, but always within this sequence.
While market regime classification can be used for market timing, its intended usage is as a compass. It tells us where the market is and what to do about it. By knowing the risk-return characteristics of each regime, we have an edge when choosing which strategies and trades we should deploy. Use this regime framework for risk management, and it works tremendously.
The Caveats
Market regime classification is fundamentally just a statistic. As with any statistic, the law of large numbers prevails. Applying market regime classification to a single instrument (a single stock) is foolish. This framework works best when analyzing a group (preferably diversified) of instruments. For example, regime classification on SPY (an S&P 500 ETF) is more reliable than on an industry-specific ETF such as SOXX (a semiconductor ETF). Using it on SOXX is far more reliable than on a single stock, such as NVDA.
Market regime classification also works much better on equity, although it can be used in other asset classes as well. Especially when used on crypto assets, while this framework succeeds in labeling the right regimes, its usage is different than on equity. More on this in future, more advanced posts.
Another caveat is that this regime classification is a lagging indicator. It uses pure price data on the assumption that everything else is already reflected in the price. The rest are statistics. The sequence is a statistic, but it is super useful nevertheless.
In Part II, we’ll discuss how to use this regime classification in the real world.
In Part III, we’ll discuss how a portfolio strategy can benefit from this regime framework.