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Since November’s landslide victory of Donald J. Trump as president of the United States, the stock market has surged to record highs, propelled by animal spirits. To understand “animal spirits,” imagine the stock market as a jungle, and investors as a pack of excitable monkeys. Picture them frolicking among the trees, with talk of “nineteen to the dozen” as the old saying goes, when the market rallies, and shrieking in panic when it declines.
“Animal spirits” was a term coined by the famous economist John Maynard Keynes. It represents the psychological and emotional factors that influence investor behavior. When confidence is high, our monkey friends are fearless, taking big leaps and making bold investments. They cheer and throw bananas when stocks rise, driving the market to new heights.
But when fear sets in, it’s a different story. The monkeys start hoarding their bananas, refusing to take risks. They huddle together, eyes wide with worry, and the market takes a nosedive. This rollercoaster of emotions – confidence fear, greed, and panic – creates the rise and fall of the stock market.
When the stock market is in rally mode, animal spirits play a significant role by driving investor optimism and confidence. When economists talk about green shoots, investors feel hopeful about the future. Believing that the trend is your friend, investors jump into the market buying stocks, even if current economic indicators don’t fully justify their optimism. This surge in buying activity pushes stock prices higher, creating a self-reinforcing cycle of rising prices and increasing confidence.
Irrational exuberance drives herd behavior as retail investors jump into the game driven by the fear of missing out (FOMO). Herd mentality amplifies market movements, eventually leading to speculative bubbles – the point at which stock prices rise far beyond their intrinsic value due to excessive optimism and speculation.
The green shoots narrative about the economy or specific sectors can fuel investor enthusiasm, further driving up stock prices. In the end, animal spirits drive markets to new heights that eventually leads to excess volatility and potential market corrections. Understanding these psychological factors is crucial for navigating the complexities of the stock market.
When investors lose confidence in the economic fundamentals, they become frozen and fear takes hold, making it difficult to make tough decisions. Much like the monkeys’ hoarding their bananas, investors get caught in a negative feedback loop as the greed quotient that led to higher prices gives way to fear and panic. The problem is that markets fall much faster than they rise.
There is a marked shift in herd behavior that causes panic selling as smaller investors try to avoid a downward spiral. Green shoots become red warning signs as the narrative changes from positive to negative. Volatility exaggerates the move to the downside. The key for money managers is to recognize the warning signs before it is too late.
So far, we remain in an upward sloping trajectory. Volatility (see chart below), based on the CBOE volatility index (VIX) remains muted, which suggests that we have not reached a speculative bubble. The narrative remains positive as economists talk about the potential benefits of corporate and personal tax cuts, which is good for corporate after-tax profits and consumer sentiment.
The main beneficiaries of this outlook will be small cap companies within the Russell 2000 index (see the iShares Russell 2000 ETF, NYSE: IWM) that have a made-in-America strategy. Such companies will gain the most from continued tax cuts and ideally, lower interest rates. They will also be immune to tariff threats because they manufacture products domestically.
So far, the results have been mixed seeing this play out. Since Trump’s landslide victory, IWM has outperformed the Dow Jones Industrial Average but has underperformed the Nasdaq 100 Index. It has performed in line with the S&P 500 index, which has been boosted by its exposure to mega-cap tech (see chart below).
We suspect this trend will continue into the new year. But once Trump is inaugurated on Monday and begins signing his threatened executive orders around tax cuts and tariffs, which now are viewed as a wash, investor psychology could change.
Economists will weigh the unintended consequences which could alter the narrative. That could shift sentiment if tariffs become a reality rather than a negotiating ploy. Companies with global exposure (e.g., Apple, Tesla, Meta, Alphabet, J.P. Morgan Chase & Co., Goldman Sachs) will be impacted by a hard-line strategy that could lead to a tit-for-tat response from trading partners.
The first shoe to drop in this high stakes poker game will be the currency markets, which will become more volatile as foreign currencies weaken against the U.S. dollar. As the U.S. dollar rises, it will hinder the ability of exporters to compete with lower-cost alternatives.
Across the US economy, prices will rise as tariffs work their way through the system. The bump in prices will be short-lived as tariffs create short-term aberrations with less intrusive long-term consequences.
Still, that could short-circuit the U.S. Federal Reserve’s ability to continue cutting interest rates. We suspect that Trump will institute a series of carveouts to dampen the short-term inflationary impact of across-the-board tariffs. Top of the list would be oil and gas from Canada. Nothing will infuriate his base more than higher prices at the gas pump.
We are not saying with certainty that it will play out this way. No one really knows! However, if we look at history as a signpost, there is a distinct possibility that the past is a prelude to the future.
The objective is to watch for the early warning signs – increased volatility in the currency markets, subtle changes in the narrative – and to act before there is a marked shift in animal spirits. You will have some time because shifts in sentiment do not happen overnight. But when sentiment does shift, the fear that will accompany a downward spiral will be palpable.
Subtle shifts in the narrative are just that…subtle. The trick is to read between the lines. For example, on Dec. 11, the U.S. Bureau of Labor Statistics released the latest inflation data. The consumer price index rose 2.7% in November, slightly higher than the 2.6% reading in October.
The focus has been on the direction of inflation and the impact that will have on how many rate cuts the market can expect from the U.S. Federal Reserve (Fed). Lower rates are good for stocks, and the notion that investors are being backstopped by a more dovish Fed has been one of the factors driving equity markets higher.
The November inflation data, while not significant, did mark a change in trend. Assuming inflation and the impact that could have on Fed policy has been one of the main drivers of rising equity prices, one would assume that the CPI data would be seen as a negative by market participants.
But when the U.S. markets closed on Dec 11, the Dow Jones Industrial Average, as expected, declined by 0.22% (-99.27 points). However, the S&P 500 index moved up by 0.82% (+49.28 points), and the Nasdaq 100 surged 1.77% to close at an all-time high above 20,000 (20,034 to be exact). So… what happened?
Obviously, daily repositioning is not a trend. But beneath the surface there appears to be a subtle shift in sentiment that may re-focus the narrative. Traders are becoming more focused on the growth story and less concerned about how the Fed is likely to react to less-than-favourable inflation data. Which is to say, traders are not relying on rate cuts to spur further upside.
The outperformance of the Mag-Seven stocks, which drove the Nasdaq 100 to record highs, is the tell. Broadcom surged 6.63%, Tesla was up 5.93%, Alphabet, Meta, Amazon, and Netflix all sitting at 52-week highs.
We are not suggesting a wholesale change in one’s investing strategy. Trying to time the market is not a particularly useful strategy. We believe it is better to engage in a risk-off trade as early warning signs become more prevalent. For example, reducing exposure to equities by transitioning some of our portfolios into short-term cash equivalents (i.e., Treasury bills or high interest saving accounts like Purpose High Interest Savings ETF, TSX: PSA).
Other strategies would include reducing exposure to passive index-based ETFs to more actively managed products. For example, reducing exposure to, say, the SPDR S&P 500 ETF Trust (NYSE: SPY) into lower-risk alternatives such as Berkshire Hathaway Inc. (NYSE: BRK.B).
Berkshire Hathaway is already holding historically high cash levels. That’s a concern, but by Buffett’s own admission, he is usually early when making strategic changes in his portfolio. Bearing in mind that his better-early-than-late strategy reflects the liquidity constraints of such a large portfolio.
Because our clients have no such constraints, we can be more light-footed. We can engage with our animal spirits, and enjoy the bullish ride while being prepared with risk-management strategies before we see a major shift in sentiment.
After all, in the world of animal spirits, it’s a jungle out there.
Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.
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Content © 2025 by R.N. Croft Financial Group Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
R N Croft Financial Group Inc. is a Licensed Discretionary Portfolio Management and Investment Fund Management company serving investors and investment professionals across Canada since 1993.
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