“Animal spirits,” a term employed by economist John Maynard Keynes in The General Theory of Employment, Interest and Money, are best thought of as the speculative impulses that cause investors to overlook fundamentals and pile into risk-on assets.
The modern equivalent, at least as of a few years ago, would undoubtedly have been the idea that an investment was going “to the moon.”
Quoting Keynes:
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 on a mathematical expectation, 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 a result of animal spirits—of 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, FOMO (fear of missing out) is not a novel or modern trait among investors.
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The problem, as the Keynes quote above shows, is that the speculative nature of animal spirits divorces trading prices from company fundamentals.
My colleague Chris Preston and I touched on it indirectly in our latest episode of Street Check in regard to Tesla (TSLA).
Specifically, we debated whether regular quarterly metrics (in this case Tesla’s car deliveries falling short) would be enough to disrupt the stock’s massive run-up.
Chris believed it would be enough to give some investors pause, while I came to the conclusion that Tesla was not valued like a traditional car company, and thus fundamental metrics like deliveries carried little weight.
We’ll see how it plays out.
So, if animal spirits are untethered from any measurable company metrics, how do we gauge their health?
Investor sentiment is one measure, as elevated sentiment measures mean animal spirits are “high” (as Keynes positioned it) and the speculative risk-on trade is in full effect.
However, when sentiment gets too high, it’s an indication that the pendulum has swung too far and is primed to reverse (usually via a market selloff).
The Investors Intelligence Bull/Bear Ratio is one frequently cited metric we can watch:
Source: Yardeni Research
A reading above 4 is generally considered overheated, and we were above that level twice in 2024. Both elevated readings were followed by brief corrections.
But … the bull market remains in full effect, and the S&P 500 and Nasdaq are both higher than they were when the Bull/Bear ratio was above 4.
For a short-term trader, the elevated reading would have been a viable sell signal, assuming that trader went long again shortly thereafter.
For longer-term investors, disregarding that Bull/Bear ratio would have been a better move than acting on it.
One place they can look, however, is market breadth, metrics that measure how much of the market is participating in the bull run.
Metrics like the NYSE Advance-Decline line, the number of stocks trading below moving averages, and the performance of other indexes, like the S&P 500 Equal-Weight Index, are all ways to take the market’s temperature.
December saw some weakness on that front, with 80% of stocks in the NYSE and S&P 500 at or below their 50-day moving averages as of the last reading and the Equal Weight index falling 6.6% for the month.
But this bull market presents risks to reading too much into those metrics too, as so much of the last two years’ performance has been driven by only a handful of stocks.
With the finicky nature of the bull market, I want to highlight three areas you can watch for a sense of the health of the animal spirits and to get a gauge of exactly how risk-on the market is.
These are, essentially, the most speculative areas of the market. If they’re thriving, risk-taking is alive and well; if they start to pull back meaningfully, animal spirits may be getting “low.”
3 Risk-On Sectors for Keeping Tabs on the Animal Spirits
Bitcoin & Cryptocurrencies
Bitcoin, which rose 131% in 2024, is a perfect encapsulation of speculative risk. It lives in bull markets and dies in bear markets, and that pattern has been a higher-quality predictor of the asset’s performance than any other.
And right now, bitcoin is signaling that the market’s appetite for risk is still going strong. The cryptocurrency just reclaimed the $100,000 level (at $102,000 as I write this) and appears well on its way to retesting prior highs.
Commercial Space Stocks
AST SpaceMobile (ASTS) and Rocket Lab (RKLB) were two of the best-performing stocks of 2024, and both companies are losing money (AST made only $1.4 million in revenues in the trailing 12 months, Rocket Lab made $364 million; neither company generated any income).
While growth stocks, in general, outperform when animal spirits are high, investor interest in novel technologies is a good measure of the level of optimism in the market.
Quantum Computing Stocks
Quantum computing stocks have recently come into vogue, and the case for tracking them closely aligns with commercial space:
-Huge levels of investor enthusiasm.
-New technology that is not yet monetized (or possibly monetizable).
-Price performance is driven by what could be.
The Gartner Hype Cycle would place both of the latter two groups on the path toward the “Peak of Inflated Expectations.”
Because investor sentiment is somewhat ethereal, it’s a risk to place too much emphasis on an easily monitored number (like the Bull/Bear ratio), but watching where the most speculative investors are pushing the most money (like the high-flying sectors above) can give you a sense of how much froth may be in the market.
When the most speculative investments start pulling back, it’s an indication that investors are becoming more risk-averse and may be looking to take profit elsewhere.
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