Animal spirits refer to the emotional and instinctive factors that influence human behavior in investment decision-making. It encapsulates the irrational aspects of human psychology such as optimism, fear, and herd mentality, which can drive market trends and deviate from rational economic models. Essentially, the basic idea supporting the role of animal spirits in asset pricing acknowledges that human decisions are not always purely rational, and emotions can play a significant role in shaping financial markets and investor behavior. Animal spirits are behind every episode of extreme financial optimism and extreme financial fear.

In other words, when it comes to investing, we humans can be our own worst enemies due to our irrationality and herding tendencies. When the herd is buying, we feel comfortable buying. When the herd is stampeding toward the exits, there is a strong desire to join the herd and sell. Often, doing the opposite of the herd can help counter our tendency to allow emotion to make things worse rather than better. This is the basic underpinning of the “buy and hold” investment philosophy. It is also behind the seminal idea behind the dollar-cost average (buying the same dollar amount every month irrespective of whether markets are up or down) approach to investing. Generally, both approaches are wise and supported by slews of data and countless academic studies. If you are going to follow a herd, follow the buy and hold herd or the dollar cost averaging herd.

There are times when animal spirits are more pervasive within the financial markets and times when it is less so. But animal spirits are never far from the surface, even in what could be considered “normal” or “placid” market environments. Some might argue we are currently amid a period of market euphoria as evidenced by things like:

1. The performance of the Mag 7 stocks, particularly NVIDIA.
2. The Performance of bitcoin and other cryptocurrencies.
3. The valuations being placed on certain growth stocks (NVIDIA being chief among them.)

Despite these things, we do not believe we are now within a period of extreme euphoria. Things may be a little frothy presently, but we do not think markets have reached euphoric levels yet. We may end up there, but we are not there yet. Here’s why we think this:

1. Mag7 stocks are up because their earnings are up. These stocks are driving a substantial majority of earnings growth within the economy. This is not like the dot com era where companies without earnings were rocketing higher. We may get there on the AI hype/hope, but we are not there yet.
2. The rest of stocks beyond the Mag7 are also experiencing commendable earnings growth and positive earnings surprises. These non-Mag 7 stocks generally have reasonable valuations. Their outlooks are improving against the favorable back drop of positive GDP growth.
3.  The performance of bitcoin is indeed accelerating, but it is nowhere near past bitcoin cycle highs. This current move is pedestrian compared to prior year-over-year moves. Here’s the chart:

 

4. The VIX index (the so-called “fear index”) is not yet showing total complacancy, but it is threatening to do so. An old colleague and former professor used to describe VIX as the price of insurance against equity declines. If                  one accepts this definition, looking at the current VIX levels in the chart below, it does not appear there is total complacency in the markets YET. If VIX drops below 10, we’d say we’ve entered a period of complacency.

What is an investor who worries about market euphoria or generalized complacency to do? The first thing is to remember both buy and hold strategies and dollar cost averaging strategies work. Doing less should always be you first consideration. The second thing to do is have a conversation with your advisor. Our advisors are here to help you think through the issues. They can remeasure your risk tolerance and evaluate your holdings if a material change in your risk tolerance has occurred. We at WealthPlan also have a few strategies that allow our clients to participate in markets as they work their way higher while also protecting the portfolio from downside shocks, should they manifest. If this sounds like something of interest to you, we’d be delighted to have that conversation.

Disclosures

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which Investment(s) may be appropriate for you, consult your financial advisor prior to investing. Information is based on sources believed to be reliable, however, their accuracy or completeness cannot be guaranteed.

No investment strategy can assure success or completely protect against loss, given the volatility of all securities markets. Statements of forecast and trends are for informational purposes and are not guaranteed to occur in the future. All performance referenced is historical and is no guarantee of future results. Securities investing involves risk, including loss of principal. Dollar cost averaging does not ensure a profit and does not protect against loss in declining markets. It involves continuous investing regardless of fluctuating price levels. Investors should consider their ability to continue investing through periods of fluctuating market conditions.

The Cboe Volatility Index^® (VIX^® Index) is considered by many to be the world’s premier barometer of equity market volatility. The VIX Index is based on real-time prices of options on the S&P 500^® Index (SPX) and is designed to reflect investors’ consensus view of future (30-day) expected stock market volatility. The VIX Index is often referred to as the market’s “fear gauge”.  An investor cannot invest directly in an index.