Now, obviously, risk has been ignored for a long time… years. That doesn’t mean risk will emerge tomorrow. But it will come.
In 1936, John Maynard Keynes gave new meaning to the term “animal spirits.” Here’s the passage from The General Theory of Employment, Interest and Money:
Even apart from the instability due to speculation, 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.
Yeah, I’m sure there are easier ways of saying it, but he’s an economist; it comes with the territory. Economists have a tendency to pretend that economics is a legitimate science, where you can come up with a perfectly accurate measurement, if you can just get the inputs right. Yeah, it’s a flawed concept from the start. Because it’s people we’re talking about.
An economy is just a group of people doing business with each other, buying and selling stuff. We humans love to pretend that we are rational creatures. Maybe on our good days, we can pass for rational. Most times, we are wildly unpredictable and impulsive. So it’s kind of nice to see an economist acknowledge the truth: that a “large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations.”
If you’ve ever lost money on a stock, you probably have a pretty good idea about what acting on “spontaneous optimism rather than mathematical expectations” means. I have been guilty of wishful thinking about a stock, too. I have absolutely told myself, “I got a feeling about this one.”
That “feeling” is Keynes’ animal spirits.
Welcome to the Jungle
Now, here’s the thing. The truth is, most economists know full well they are social scientists. Economies grow strongly when people feel good about things. And economies do poorly when people aren’t feeling so great.
You can measure non-farm payrolls, you can monitor prices for stuff and make some generalizations about inflation, you can check in with manufacturing (NYSEARCA:XLI) output, but at the end of the day, all these things are designed to do is gauge how people are feeling about the economy.
And that’s why the entire U.S. economy has been so frustrating since the financial crisis. Manufacturing has expanded pretty steadily, borrowing has been cheap, employment has steadily risen, stocks have done great… and yet the general mood has been a bit depressed. Economists have been unable to make any sense of it. But, from where I sit, it makes perfect sense…
In 2008 and 2009, we stared into the abyss. We saw America and capitalism in flames. Remember that Friday when we were advised to get cash from an ATM because they might not be working on Monday? Yeah, that.
We all know that any system is based on belief. Paper money only has as much value as we believe it does, just like gold or Bitcoin or puka shells. But that belief — our spontaneous optimism — is very strong. You certainly don’t expect to ever see such a massive belief system nearly collapse like it did during the financial crisis. That kind of experience leaves scars.
I blew my knee out when I was a Colorado ski bum in 1991. It was a solid couple of years before I could really pivot on that leg without thinking about it. So I’m not at all surprised that it’s taken eight years for animal sprits to return to the economy. But that’s exactly what’s happening right now. Animal spirits have finally been unleashed.
Do You Have a Plan?
It’s easy to think of animal spirits as a kind of bubble mentality. Like, I could tell you the S&P 500 (NYSEARCA:SPY) is up 19% since the election when not much has changed with the economy, and we could conclude that yes, animal spirits have pushed valuations higher for no real reason.
But then I’d have to tell you that at this time in 2013, the S&P 500 was also up 19% since the 2012 election. And I don’t think anyone would say there was any spontaneous optimism going on then (maybe we just have short memories).
Still, animal spirits is more than just stock prices. GDP growth was over 3% in the second quarter. It likely would be hitting 3.5% for the third quarter if not for the hurricanes. It seems likely that we will see strong a fourth quarter, too. Consumer spending(NYSEARCA:XLY) and business spending have been doing surprisingly well. Manufacturing surveys are hitting multi-decade highs. Consumer sentiment is off the charts. We are getting a lift from the global economy, too. And, perhaps most amazing of all, wages are starting to show some growth.
Yep, everything is coming up roses…
Third-quarter earnings season starts this week. It is likely to be another good one. Analysts are calling for there to be actual revenue growth, something that’s been missing and glossed over by stock buybacks and cost-cutting.
So, I gotta ask, do you have a plan?
The reason I ask is that when the animal spirits get unleashed, it’s very easy to get swept up in the frenzy. And, in fact, you should be swept up in the frenzy. You gotta make hay when the sun is shining. But let me amend Keynes’ observation that “a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations” a little bit. Let’s make it “a large proportion of our investment decisions depend on spontaneous optimism rather than mathematical expectations.”
Humans are emotional creatures. Many of us buy stocks when we think we can make money. In other words, gut feeling.
The most successful investors and traders understand this. They know they are an emotional freak show. So they use rules to keep their emotions out of their trading.
One common rule for protection is the trailing stop. If you put it at 10%, it means that if the stock falls 10% from its most recent high, you sell it. No questions asked.
If you aren’t using trailing stops, you should. Because as tame as the animal spirits seem right now, they can turn mean. They will absolutely bite the hand that feeds. I’m not going to tell you this market is overvalued. Maybe it is, maybe it isn’t. We won’t know until we see earnings. But what I will tell you is that this market simply does not acknowledge risk. It is as if there is now downside. And that is a dangerous situation.
Now, obviously, risk has been ignored for a long time… years. That doesn’t mean risk will emerge tomorrow. But it will come. The main driver for stocks is lockstep algorithm ETF investing. Everything just marches higher. When all those buyers turn to sellers at the same time, the phrase ” gut wrenching” comes to mind.
So, take the emotion out of it, and put some stop losses on your investments so you can really enjoy the ride.