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.
Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these assets. You should do your own thorough research before making any investment decisions. FXStreet does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Open Markets involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility. The views and opinions expressed in this article are those of the authors and do not necessarily reflect the official policy or position of FXStreet nor its advertisers.