Spiritus Animalis

“Identified in the 1930s by John Maynard Keynes as an important economic driver, he said an eruption of ‘animal spirits’ could start a virtuous circle of entrepreneurial risk-taking and investment- and further lift equities.”  – Financial Times lexicon

When Keynes’ “animal spirits” theory made its first appearance in his 1936 book, The General Theory of Employment, Interest and Money, economists were still trying to explain the cause of the Great Depression.  At a time when conventional wisdom stated that individuals always made economic decisions that were rational, Keynes provided evidence that human beings did no such thing.  He surmised that business leaders will never have all of the desired facts available to them when determining spending levels, requiring them to rely at least in part on their “guts”.  The same holds true for investors.  In addition, humans are influenced by the “crowd” and can behave somewhat like lemmings if the majority of the crowd is also optimistic or pessimistic.  Reliance on instinct and herd mentality help explain why businesses over or under invest and why stock prices can reach extreme valuation levels.  Keynes’ analysis of the Great Depression was ground-breaking at the time and still holds true today.

Since the November presidential election, we’ve witnessed Keynes’ “animal spirits” theory play out.  Stock market levels have moved higher on investor optimism that the tax cuts, regulatory reform and infrastructure spending promised by the new president will have a significantly positive impact on future corporate profits.  This optimism is shared by small business owners and corporate CEOs as indicated by post-election confidence surveys.  Higher business confidence leads to increased spending on new projects, increased production levels and higher employment levels.  It will take some time for these investments to lead to tangible results, so this pick-up in business spending won’t be reflected in the economic data for several months.

Does this mean that “animal spirits” behind the post-election stock market rally have already priced all of the anticipated benefits of increased business spending?  In our view, there’s certainly less room for further gains until markets see the results of higher spending.  If the data fall short of market expectations, then the market has likely established a near-term high.  Data that exceeds expectations could drive prices higher.  We won’t know for sure for several months.

As discussed in last month’s investment commentary, (High Anxiety Over High Equity Valuations), extended valuations alone usually fail to trigger a bear market.  At least one of the following conditions – recession, higher than expected inflation or faster than expected interest rate increases – need to manifest themselves first.  On the other hand, corrections (defined as a decline of 10% or more from market highs) can and do happen on a fairly regular basis and are typically good buying opportunities.

In our view, the Fed is unlikely to deviate from their forecast of two additional quarter point rate increases in 2017 – so no surprises there.  Rising inflation could surprise markets, but the most recent Federal Open Market Committee (FOMC) comments indicate it doesn’t expect inflation to move high enough to justify additional rate hikes.  The start of a recession may have the highest odds of making an appearance this year, but there’s strong historical data that shows a high correlation between a spike in unemployment rates and the start of a recession.  At present, the unemployment rate sits at 4.7%, just a tenth of a point above the cyclical low of 4.6% set in November 2016.  Of course conditions are subject to change, in which case so will our expectations.

Our portfolios are constructed to reflect each client’s unique goals, time horizon and risk tolerance as determined in his or her financial plan.  These plans are prudently monitored and periodically adjusted to help you stay on track to achieving your financial goals.  It’s important to note that your goals today may be quite different from your goals in the future.  Meeting with your fiduciary investment advisor at least annually will help make sure your investments continue to align with your goals.  We are with you every step of the way.

Bottom Line:
“Animal spirits” have been a major factor in the post-election stock market rally and have sent valuations into nosebleed territory.  However, elevated valuations alone are usually insufficient to trigger a bear market.  Valuations have stayed at elevated levels for extended periods of time in the past and that could be the case again today.  A correction in the near-term would not be surprising, but we’ll need to see additional negative signs before believing the odds favor a bear market.  We will be closely watching for those signs – impending recession, unexpected spikes in inflation and interest rates – to show up in the data.  In the meantime, we maintain our current course.

About Chad Sturgill view all posts

Chad Sturgill is a Senior Portfolio Manager for Unified Trust Company. He is responsible for developing and executing investment strategies for individual and institutional clients and in turn making and implementing recommendations to the Trust Investment Committee. He leads the Dividend Growth Portfolio team of analysts and dictates investment strategy messaging.