Goldman Asks: Are Markets Rationally, Or Irrationally, Exuberant?


Goldman Sachs’ Charlie Himmelberg and Marty Young find evidence that “animal spirits” are driving sentiment along party lines… and that may be a concern…

Sentiment indicators have rallied hard since the election of Donald Trump. The Conference Board’s Consumer Confidence Index, for example, has risen to its highest level since December 2000 (+24.8 points from October). The University of Michigan’s survey of consumer sentiment has also rallied (+10.8 points). And the NFIB measure of small business optimism (+9.8 points since October) hit a post-crisis high in December following its largest two-month move since 1986.

There is active debate over the reasons for this improvement. To some extent, it likely reflects improvements in the underlying macro data leading up to the election. The unemployment rate, for example, fell from 5.0% in April to 4.6% in November. On the other hand, many investors believe that the rally in US sentiment (and asset markets) reflects post-election expectations of tax cuts, infrastructure and defense spending, and deregulation. Indeed, our US economists expect fiscal easing will cumulatively add 0.6% to GDP in 2018-2019.

We see a third factor at work—“animal spirits.” In the tradition of Keynes and his modern interpreters (e.g., Akerlof and Shiller), we define this term to mean “irrational” economic beliefs (driven by emotion, instinct, political opinion, etc.) that cannot be explained by either recent macroeconomic data or by plausible future developments. While it is often difficult to distinguish animal spirits from rational expectations, we think differences in sentiment along demographic characteristics can help shed some light.

Perspectives along party lines

A fascinating feature of post-election sentiment is the divergence in assessments of the economic outlook along party lines. As of April 2, the gap between Democrats and Republicans in the Bloomberg Consumer Comfort Index (BCCI) had increased to its widest level since early 2009.

The correlation between economic sentiment and political affiliation is also visible in regional data. The regions that voted strongly for Trump are the regions that are most optimistic about the future. Interestingly, these expectations do not appear to reflect current conditions; the regions that voted for Trump are the regions that have the lowest assessment of current conditions, suggesting the jump in expectations was a response to the election.

Rationally or irrationally exuberant?

Sentiment differences along party lines could well be rational. Voters in West Virginia, for example, might be “rationally exuberant” over the expectation that regulatory policies will be “pro-coal.” But we suspect there is more to the story than can be rationalized by rationality.

There are reasons sentiment may have been more vulnerable to animal spirits following this election. Voters (like many economists) were likely puzzled over why the last recession was so severe, why the recovery was so sluggish, or why many real incomes failed to rise. This absence of compelling answers may have undermined the credibility of “official” explanations, leaving sentiment vulnerable to ambitious narratives about future growth. Or as Akerlof and Shiller put it in their 2009 book: “The stories no longer merely explain the facts, they are the facts (“Animal Spirits”, 2009, pg. 54).”

The distinction between rational and irrational sentiment matters. If improvements in sentiment “rationally” reflect recent macro data or “news” about future developments, they likely foreshadow stronger growth. But to the extent that sentiments are “irrational,” they leave the economy more vulnerable to cycles of overheating and correction.


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