Animal Spirits: Are they Justified this Time?

“Animal Spirits” is the latest buzzword being used to describe the powerful market rally that continues to occur since President Trump was elected on November 8th. In fact, the S&P 500 has rallied over 11% since the election. What exactly are animal spirits?

Famous Economist John Maynard Keynes used the term in his book The General Theory of Employment, Interest, and Money, saying: “there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.”

In other words, animal spirits is the feeling that something good will happen, even though the outcome is uncertain.

President Trump’s plan calls for lower taxes and increased spending on infrastructure and defense. Broken down to a simplistic formula, more spending and less revenue through taxes equates to more government debt. How much more? For estimate sake, the Tax Policy Center (TPC) (which aims to be nonpartisan) claims that Trump’s tax cuts will raise the National debt by approximately $7 Trillion by 2026 ($700 billion per year). Assuming this number is in the ballpark, it’s no wonder the market has rallied, as an extra $700 billion a year in fiscal stimulus should be great for the economy. But will these measures finally produce sustainable growth? “Animal spirits” would say yes.

Like President Trump’s plan, recent actions by the Federal Reserve also caused “animal spirits.” On March 18, 2009 the Fed announced that it would inject over $1 Trillion into the economy by purchasing mortgage backed securities and Treasuries, otherwise known as QE1. This large amount of stimulus was well received by the market, propelling the S&P 500 up 19% in 3 months. However, upon seeing that QE1 was not spurring the desired level of growth, the Fed decided to unleash QE2 by injecting $600 billon into the economy through asset purchases. This again got the “animal spirits” of investors flowing, pushing stocks up by over 12% in 3 months. Despite “animal spirits” pushing stocks to new all-time highs, the stimulus through QE1 and QE2 was only able to produce an average of 2% growth since the great recession.

Turning back to present day, will President Trump’s tax cuts spur the economy and finally satisfy the “animal spirits” of investors? History tells us that tax cuts have had a simulative effect in the past. However, it is less certain how effective they will be at current debt levels. Remembering that our current debt to GDP ratio is approximately 105%, history has shown that once debt to GDP rises to 100% growth slows significantly. Additionally, since the end of the great recession in 2009, it has become evident that more government debt ($8.431 trillion) on top of several trillion in monetary stimulus has done little to spur economic growth.

The main question then becomes: how should one invest their hard earned savings with so much uncertainty?  After all, if the tax-cuts work we may be at the beginning of another economic expansion that will leave the US in great shape going forward.  However if they are unsuccessful, we will have a suffocating level of debt with nothing to show for it.

First, it is important to remember that the stock market is not the same as the economy. Due to investors’ feelings and emotions, stocks can swing to extreme positives and negatives. Second, investors who focus on the longer-term perspective should be mindful that the presidential election occurs every 4 years. Third, successful investors shouldn’t chase returns or panic by avoiding the market all-together. Rather, they should pick an allocation of stocks, bonds, and alternatives that allows them to both meet their goals and sleep at night.

As a long-term investment advisor, we do not rely on “animal spirits”, hopes, or our individual feelings. We stick to our time-tested strategy of investing in closed-end funds that are trading at a discount to their underlying value. This allows us to logically identify undervalued securities and sectors with the potential for attractive returns.

2017-03-09T16:05:43+00:00 March 9th, 2017|Daniel Lippincott|

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