Analysts at Barclays attracted plenty of criticism at the beginning of February when they published a research note claiming that so-called “animal spirits” were now in control of investors and the presence of these spirits will ensure equity markets continue to push higher, no matter what the macro economic backdrop.

Barclays: Forget Valuations! Animal Spirits Are Driving The Market Higher

The topic of so-called “animal spirits” is the focus of the April issue of Goldman Sachs’ monthly Top of Mind global macro research booklet. The booklet features an interview with economist Roger Farmer, who argues that market sentiment can be self-fulfilling, which means the “animal spirits” argument is not so difficult to comprehend after all.

Goldman: Why Animal Spirits Do Control The Market

“Animal spirits are the psychological drivers of economic activity: “a spontaneous urge to action rather than inaction,” in the words of John Maynard Keynes who discussed them in his 1936 work, The General Theory of Employment, Interest, and Money. Put differently; animal spirits are the sentiments that prompt decisions about investment and spending, even in the face of uncertainty. Economists Robert Shiller and George Akerlof—among others—have argued that animal spirits can explain changes in asset prices beyond what fundamentals would imply.” – Goldman Sachs

Roger Farmer argues that animal spirits are incredibly important to growth as consumption accounts for around 70% of GDP and if confidence erodes, that can have a big impact on consumption. Unlike many other economists, Farmer’s work argues that changes in the stock market not only predict changes in unemployment but actually cause them. Therefore, a stock market driven by investors’ animal spirits is good news for the wider economy as a whole.

Indeed, Farmer’s research shows that a persistent 10% drop in the stock market will be followed by a three percentage point increase in the unemployment rate 6 to 12 months later. Day-to-day stock market movements are irrelevant because as Farmer points out if you’re “a 65-year-old couple thinking of going on a cruise and your 401(k) declines by 10%. If it arises again the next week, that doesn’t influence much. But if the drop persists, you may start to worry and cancel the cruise.”

Farmer goes on to argue in the interview that the stock market Granger-causes the future unemployment rate, meaning that the former provides information that helps predict the latter. And this is potentially good news for economic growth:

“As long as people remain optimistic and keep spending, perhaps for other reasons such as positive data, that in my view will be enough to maintain momentum in the economy, which could, in turn, continue to propel markets. That said, I would caution that other important drivers of growth, like technology and demographics, have little to do with confidence and the stock market. And in the big picture, at least one of those two—demographics—looks less favorable for growth.”

Unfortunately, the economist does not believe that this growth trend is set to continue forever. In fact, even though he believes that the stock market is unlikely “to correct tomorrow, even if prices and valuations look high by historical standards” further out there is likely to be a significant correction and with interest rates so low, “there’s no ammunition to prevent that from leading to a major recession.” Farmer goes on to say that he believes the 2008 stock crash have a much more lasting impact than the 1987 crash because rates were higher at the time. Unless there is a very sudden and sharp increase in rates to 5% or 6%, there will be no ammunition to fight the next downturn when it occurs. And Farmer has an interesting idea of how the Fed should manage the next market collapse when it arrives, based on his research which shows the interconnectedness of the stock market and economy:

“I would like to see the Fed, the Treasury, or some other government agency actively intervene to prevent volatility. If you’re going too high in a hot air balloon, the solution is not to stick a pin in it and crash down; it’s to install an escape valve and come down slowly. Today, I worry that if the Fed raises rates too quickly, that’s a bit like using a pin. The Fed should instead act to prevent large stock movements, both on the upside and on the downside, from adversely affecting the economy. It would assert this control by managing the value of an indexed fund defined over all publicly traded assets. The FOMC would announce a price path for this fund, and the Fed would stand by ready to buy and sell at the announced price. That’s my version of an escape valve.”