Animal Spirits & Market Dynamics - Navigating Early Warning Signs

Comments on social media platforms were stirring when Barron's published this cover in early March. Many experienced investors view a Barron’s cover as a reliable contrarian indicator since it typically highlights a popular trend in the late stages. This contrarian view does have merit if you look at the history of past covers, although it tends to work as an early warning sign rather than an immediate signal to act. 

I view this as one more early warning sign, within a series of warning signs, that “animal spirits” are beginning to stir investors. Animal spirits is a term used in investing, where decisions are made based on emotion rather than intrinsic value. When “fear” is replaced with “fear of missing out,” people buy stocks simply because they are going up. Look no further than a recent chart on Bitcoin or shares of Nvidia, and you will see what I mean. This typically sets up a situation known as a “blow-off top,” where risk assets rise significantly for some time before economics and financial markets finally come head to head and figure out which sets of data are correct. Either the economic numbers will improve and catch up to stock prices, or stock prices will come down to match current economic realities. 

Stocks have had a great start to the year and continue to trend higher; however, macroeconomic charts that measure leading economic indicators have mostly been falling. Indicators such as bank lending, housing prices, household savings, and job openings have fallen significantly, while delinquencies in credit and auto loans, interest payments on debt, and bankruptcies have drifting higher. There are quite a few more economic indicators that historically have been reliable predictors of past recessions that are flashing warnings. However, the exact timing of when a recession may begin and the severity or damage a recession may cause are not precise sciences. Most warning signs start flashing many months in advance before a recession occurs. A recession is actually a normal part of the business cycle and is simply a decline in economic activity that can last a few months or years. Some recessions are mild and short while others can be quite severe causing high unemployment and deep losses in asset prices.

According to the World Economic Forum, in early 2023, about two-thirds of chief economists believed a recession would happen last year. This belief spread to most financial news media outlets and contributed to a “wall of worry” for investors to overcome all year. However, the recession never showed up, and here we are in 2024. 

Fortunately, for the benefit of our clients, we did not accept this recession narrative last year. Based on our internal research and help from our independent partner research firms, we stuck with a bullish stance for all of 2023, resulting in profitable returns for our Ranch Cap model portfolios and our clients who invest in them.

However, if you ever had the pleasure of raising a teenage daughter, you might be familiar with the expression, “That was so last year.”

To get to the point, we do see storm clouds gathering, but it is still too early to bring out the umbrella. Animal spirits can cause prices to increase further than one might expect, and we believe there is still momentum in risk assets. It is challenging to have a recession when the labor market is robust (low unemployment), and people are still consuming and spending at record levels. However, a lot of money was handed out during the COVID era, and those excess savings are just about dried up, and now interest payments for credit are very burdensome. Typically, a downtrend in job openings leads to the next phase: an increase in job layoffs. This has not happened as of yet, but we are monitoring the unemployment reports for deterioration.

In conclusion, the sun is still shining for risk assets, but it is also a good time to start thinking about which umbrella is best for you and how you would prefer to deal with a potential storm. Some investors are willing and able to “ride it out,” while others prefer to hunker down and stand aside. For many investors, it may be a little of both. However, factors such as time horizons, capital gains taxes, investment income, liquidity needs, and personal situations will most certainly need to be considered. We anticipate making defensive adjustments to our models over the next few months, especially if we get the "blowoff top" we expect.

It is an excellent time to meet with your investment advisory team and plan ahead. Better to make plans when the skies are clear and you have plenty of chips on your table.