The Roar of the Animal Spirits: A New Index

“There’s no good idea that cannot be improved on.” - Michael Eisner

Executive Summary

Major U.S. equity indices are at all-time highs, with the S&P 500 index closing above the 2,700 mark in early January for the first time ever. Whispers that animal spirits are at play are being heard around the markets. Keynes stated that animal spirits are one of the key factors behind fluctuations in the economy and changes in the business cycle. Therefore, a quantitative measure of animal spirits may lead to a more accurate estimation of the potential effect that a change in animal spirits has on the economy. Furthermore, it would be helpful for decision makers to understand the underlying drivers of animal spirits, thus giving them the ability to directly influence animal spirits.

In this report, we introduce a new index to measure animal spirits. In our opinion, instead of relying on a single variable, like the consumer confidence index or S&P 500 index, it would be more informative to construct an index based on several indicators to represent different behaviors across major sectors of the economy. An economy consists of many sectors, and economic agents in those sectors react differently to various policy changes and business cycle phases. For example, the consumer confidence index has increased 173 percent in the post Great Recession era, but personal consumption has increased just 22 percent during the same time period. Similarly, the S&P 500 index has produced one of the largest gains in the current recovery, but the current economic recovery is among the slowest in the post-World War-II era. Therefore, a single indicator may not have the ability to fully capture the animal spirit variable, presenting a need to include information from various major sectors of the economy to construct a more reliable and comprehensive measure of animal spirits.

Our Animal Spirits Index (ASI) includes information from five variables, which are, (1) the S&P 500 index, (2) the Conference Board’s consumer confidence index, (3) the yield spread, (4) the VIX index and (5) the economic policy uncertainty index. These five variables capture actions of major economic agents while representing major sectors, and have the ability to shed light on economic agents’ expectations about the near-term economic outlook. We utilize a dynamic factor modeling (DFM) approach in constructing our index.

Our ASI goes back to January 1967, giving us the opportunity to analyze the index’s behavior during different business cycles and political environments. In analyzing our index, we note key observations that not only set this business cycle apart from prior cycles, but confirm the severity of the Great Recession and the slow recovery that has followed it.

The focus of this report is to present our ASI and its methodology. In the reports to follow, we will estimate the animal spirits’ effect on the economy, while highlighting the key drivers of our ASI.

Historical Perspective: The Good, the Bad and the Ugly of the ASI

Keynes once remarked that animal spirits were one of the key factors behind fluctuations in the economy. More recently, Akerlof and Shiller suggested that human psychology drives financial events worldwide, as seen in the ever-rising home prices of the mid-2000s to plummeting confidence in capital markets in the fallout. 1 Simply put, human psychology plays an important role in business cycles. However, emotional forces cannot be looked at in isolation. Animal spirits as well as monetary and fiscal policy feed off one another. When policymakers step in to restore confidence through either fiscal or monetary policies they often do so with the knowledge that it will likely energize animal spirits. Confident investors are more likely to invest in creating a supply of goods and services that helps drive employment. Likewise, if consumers are hopeful about the future, personal consumption is likely to pick up, which is a major component of GDP.

There are several examples of movements in animal spirits during the 2008-2010 period that demonstrate the effect that animal spirits have on the economy (Figure 1). For example, when the U.S. House of Representatives failed to pass the Troubled Asset Relief Program (TARP) on September 29, 2008, the S&P 500 index dropped more than 8 percent that same day. The S&P 500 index proceeded to drop more than 20 percent the next month, the worst month for the S&P 500 index since April 1932. However, when Secretary of the Treasury, Timothy Geithner, announced a program to buy toxic assets from banks’ balance sheets in March 2009, the S&P 500 index gained more than 22 percent during the March-June 2009 period, a sign that confidence was partially restored. Also contributing to the equity rally was that bank stress tests showed that banks did not need to be nationalized as some had feared. Policymakers have a tremendous influence on animal spirits, which in turn can influence the behavior of financial markets.

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For example, you place an order to buy at a stop of $50 which is above the current price of $45. If the price of the stock moves to or above the $50 stop price, the order becomes a market order and will execute at the current market price. Your trade will be executed above, below or at the $50 stop price. In a fast market, the execution price could be drastically different than the stop price. A "sell stop" is very similar. You own a stock with a current market price of $70 a share. You place a sell stop at $67. If the stock drops to $67 or less, the trade becomes a market order and your trade will be executed above, below or at the $67 stop price. In a fast market, the execution price could be drastically different than the stop price. A stop limit has two major differences from a stop order. With a stop limit, you are not guaranteed to get an execution. If you do get an execution on your trade, you are guaranteed to get your limit price or better. For example, you place an order to sell stock you own at a stop limit of $67. If the stock drops to $67 or less, the trade becomes a limit order and your trade will only be executed at $67 or better. Glossary All or None (AON) A stipulation of a buy or sell order which instructs the broker to either fill the whole order or don't fill it at all; but in the latter case, don't cancel it, as the broker would if the order were filled or killed. Day Order A buy or sell order that automatically expires if it is not executed during that trading session. Fill or Kill An order placed that must immediately be filled in its entirety or, if this is not possible, totally canceled. Good Til Canceled (GTC) An order to buy or sell which remains in effect until it is either executed or canceled (WellsTrade® accounts have set a limit of 60 days, after which we will automatically cancel the order). Immediate or Cancel An order condition that requires all or part of an order to be executed immediately. The part of the order that cannot be executed immediately is canceled. Limit Order An order to buy or sell a stated quantity of a security at a specified price or at a better price (higher for sales or lower for purchases). Maintenance Call A call from a broker demanding the deposit of cash or marginable securities to satisfy Regulation T requirements and/or the House Maintenance Requirement. This may happen when the customer's margin account balance falls below the minimum requirements due to market fluctuations or other activity. Margin Requirement Minimum amount that a client must deposit in the form of cash or eligible securities in a margin account as spelled out in Regulation T of the Federal Reserve Board. Reg. T requires a minimum of $2,000 or 50% of the purchase price of eligible securities bought on margin or 50% of the proceeds of short sales. Market Makers NASD member firms that buy and sell NASDAQ securities, at prices they display in NASDAQ, for their own account. There are currently over 500 firms that act as NASDAQ Market Makers. One of the major differences between the NASDAQ Stock Market and other major markets in the U.S. is NASDAQ's structure of competing Market Makers. Each Market Maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the Market Maker will immediately purchase for or sell from its own inventory, or seek the other side of the trade until it is executed, often in a matter of seconds. Market Order An order to buy or sell a stated amount of a security at the best price available at the time the order is received in the trading marketplace. Specialists Specialist firms are those securities firms which hold seats on national securities exchanges and are charged with maintaining orderly markets in the securities in which they have exclusive franchises. They buy securities from investors who want to sell and sell when investors want to buy. Stop An order that becomes a market order once the security has traded through the designated stop price. Buy stops are entered above the current ask price. If the price moves to or above the stop price, the order becomes a market order and will be executed at the current market price. This price may be higher or lower than the stop price. Sell stops are entered below the current market price. If the price moves to or below the stop price, the order becomes a market order and will be executed at the current market price. Stop Limit An order that becomes a limit order once the security trades at the designated stop price. A stop limit order instructs a broker to buy or sell at a specific price or better, but only after a given stop price has been reached or passed. It is a combination of a stop order and a limit order. These articles are for information and education purposes only. You will need to evaluate the merits and risks associated with relying on any information provided. 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