Animal Spirits

The term Animal Spirits seems to have replaced The New Normal as the description of choice for economic commentators.     The new normal describes an indefinite state of slow economic growth, while animal spirits represents a more positive outlook that is underpinning the surge in stock prices since the November election.    While intriguing language, neither term helps much with understanding or navigating the financial markets.    Let me give you my perspective and a potential solution to the inherent uncertainty of the current financial climate.

The economy has been recovering at a snail’s pace since the financial crisis, but that does not mean that it will always be this way.   We are not destined for any specific path and many attributes can influence the future with policies and practices that support economic growth.  The animal spirits in the market just reflect this current potential.   It doesn’t take great insight to understand that infrastructure spending, a more efficient business tax structure and less difficult regulations would promote higher corporate profits and stock prices.   Having claimed control over all three branches of government, the Republicans are planning to introduce legislation to address each of these areas.   Prices already assume legislative progress will be made and some success will be achieved.     The devil is in the details, though.  Substantive actions and real success will be needed to maintain the current level of the stock market - much less push it higher.    Therefore, success is far from a sure thing.  

Paradoxically, it is this uncertainty that allows for stronger returns from the stock market.   With this current uncertainty absent, stocks would not return more than bonds.  The perceived risk is what drives the expected return. Law makers had better deliver on the promise of a better environment for public companies and small businesses.   If you think voters are unforgiving, wait until you see how investors respond if results fail to match expectations.    The animal spirits will disappear faster than La La Land’s Best Picture Academy Award.

By many metrics, the stock market was over-valued before the post-election gains, which makes it even more precarious now.  There is not much room for error, so this is not a time to take extraordinary risk.   Even so, I think it would be an overstatement to suggest that we’re in bubble territory.   I’m cautiously optimistic for the short-term, because the fundamentals of the economy appear to be strong.  Based on my belief in the future prospects for the world economy, I’m also pretty hopeful about the long-term.  However, I’m not so confident for the period in between.   In other words, I don’t think investors should be afraid to commit long-term capital to the stock market, but I wouldn’t let the animal spirits go to my head either.

Has there ever been a time when the future was not this uncertain?   I’m not sure things are greatly different than they have been in the past.    Republicans and Democrats have never gotten along well.   There have always been physical threats and instability around the world.   Technology continues to advance relentlessly.   Stocks have always been volatile and bonds have always been susceptible to fluctuation in interest rates.    Investors should be cautious at the current stock market level, but hasn’t that always been the case?  

I’ve witnessed many changes in the economy and the markets over the years, but in my view the solution remains essentially the same.    To achieve long-term goals, you must invest for the long-term.  That is, you have to be in the game - and stay in the game – until your long-term goals have been met.    For this strategy to work, you need a plan and the discipline to stick to it.   The foundation of any plan must be diversification and having the appropriate asset allocation at all times.     Proper asset allocation – that is consistent with your personal situation and risk profile - will not generate the greatest returns, but it should keep risk to a manageable level.  Only then will you have the fortitude to stick with the plan.

Current valuation levels still do pose a significant problem.  It could be argued that all asset classes are overvalued.    Do you want to own bonds in the face of a likely rise in interest rates?   How about cash with short-term rates still at record lows.   Real estate has done well in recent years following the crash, but it might be even more overvalued than the stock market.   Commodities don’t offer any sanctuary either.  What then is an investor to do?  If I had a crystal ball, I’d know exactly what to do.   Since I don’t, it makes sense to take a cautious and balanced approach.     

I believe that stocks will perform better than bonds over the long run, as they have done so in the past.   I also believe that bonds will earn very little, but still play a necessary and important role in a portfolio.   Cash is still just for emergencies and short term needs.  Real estate is a good diversifier, but still risky.   Commodifies are not generally desirable in a portfolio.   The more things change, the more they stay the same. 

Keeping costs low is another critical component and more important than ever in the face of meager asset returns.   Expenses reduce your rate of return by surrendering part to financial intermediaries who do not add value, leaving less for you to keep.    Fortunately, index funds make low-cost investing available to everybody.  Whereas you can’t control many aspects of investing, you can control expenses and by doing so increase your personal margin for error.

Despite the prevailing market levels, my basic approach to designing and maintaining an investment portfolio has not really changed.   The allocation that I would recommend today for a moderate risk portfolio is about the same as I might have suggested even possibly twenty years ago.  Of course, I would use index funds almost exclusively now, but the manner of managing risk and planning for the future has not changed much.  A few simple and time-tested strategies can allow you to navigate an uncertain investment world pretty effectively.  

The animal spirits might signal good things ahead, or they might be fleeting.  Managing risk is always a key component of an investment plan.  If you have a fundamentally sound plan, it is important to stick with the plan.   This includes keeping your portfolio in-line with the intended risk profile.  While I can’t predict the markets, or totally understand the short-term nature of animal spirits, I believe that a disciplined approach will ultimately lead to long-term success.