Animal spirits are running high. Is that bad?

With the stock market wobbling this week, some investors have become worried that gains of the past few years could be poised to unwind. In particular, these investors point to the disconnect that recent price gains do not appear to be justified by stock-market fundamentals, such as earnings growth, as evidence that the market has gotten unsustainably ahead of itself.

In my opinion, it's true that bullish animal spirits have been the primary driver of this market. This is evident by the fact that stock-market returns for most of last year were driven by an increase in price-earnings ratios (PEs) that exceeded earnings growth. The chart below illustrates this point. For the 12 months ending in September 2024, rising PE ratios accounted for the disproportionate majority of the more than 30% annual return for the S&P 500^® Index, with earnings growth accounting for a relatively small portion of returns.

PE ratios cannot rise indefinitely, which is why over longer periods stock gains are supposed to generally track earnings.

Animal spirits and subsequent market returns

Does the presence of animal spirits mean the stock market must pull back to bring PE ratios in line with the current level of earnings growth?

Actually, the opposite may be true: A continued advance in which earnings eventually catch up to PE expansion may be the more likely scenario. Going back to the 1930s, markets driven by animal spirits went on to generate nearly double the returns of markets driven by earnings growth (based on subsequent 12-month returns).

This happened even though markets driven by animal spirits generally had higher starting-point valuations.

Counterintuitively, high animal spirits also don’t necessarily lead to high market volatility. One indicator that has been historically predictive on this point is valuation spreads, meaning the difference in valuations between the most-expensive and least-expensive stocks. Valuation spreads measured by book yield (meaning, annual dividend divided by book value per share) recently reached top-decile levels, based on data since 1990. Historically over that same period, top-decile valuation spreads have generally been followed by below-average market volatility and above-average risk-adjusted returns over the next 12 months.¹

Animal spirits and subsequent earnings growth

What about the continued health of stock fundamentals? If the market has been driven by rising PE ratios, does that mean it’s merely running on hot air?

In fact, the presence of animal spirits has historically tended to point to durable earnings growth in future years, even in an expensive market.

Going back to 1936, markets driven by animal spirits that were also in the top quartile of valuations over the period generated significantly better aggregate earnings growth over the next 3 years on average, compared with markets that were primarily driven by earnings growth.

Support for future earnings growth could come from rising profit margins. On this point, one indicator I like to watch is the Consumer Price Index (CPI) versus the Producer Price Index (PPI). In recent years, consumer prices have been rising more than producer prices. This historically has signaled a good environment for profit-margin expansion, because it suggests that the prices companies charge consumers are rising faster than the prices companies pay for inputs. Since 1962, operating margins have generally expanded after periods when the CPI rose faster than the PPI.²

Cyclical sectors could be poised to lead

Growth-oriented cyclical sectors have historically performed meaningfully better than defensive sectors in the presence of animal spirits. This group includes communication services, consumer discretionary, energy, financials, industrials, materials, real estate, and technology.

Although past performance is no guarantee of future returns, since 1936 cyclical sectors have outperformed defensive sectors by about 6 percentage points over the following 12 months, after periods when the market was driven primarily by PE expansion.³ That relative-return advantage for cyclical sectors has historically persisted over subsequent 3-year periods as well.⁴

What about high-flying AI stocks?

Despite the presence of animal spirits, some investors question if growth-oriented cyclical stocks can outperform given current market valuations and a high level of market concentration. Some worry that a small group of artificial intelligence-related (AI) stocks that have doubled or tripled since 2022 may be vulnerable to declines.

Many AI stocks sold off in January after DeepSeek, a China-based AI company, announced that it had developed and trained a competitive large language model (LLM) at a significantly lower cost than US-based competitors. Questions arose as to whether US companies might be at a technical disadvantage that makes their stocks overpriced.

One counterargument to this is that in the coming months, competing LLMs may start to focus on developing power innovations like the ones invented by DeepSeek. This could lower prices and boost the overall adoption rate of AI technologies, benefiting specific technology segments, such as software makers for which AI is a major development cost.

Moreover, as of early 2025, growth stocks do not appear historically expensive based on relative valuations (which I measured by comparing the earnings yield, or earnings divided by price, of growth stocks versus the broader S&P 500).

In fact, if anything they look relatively cheap, compared with historical relative valuations. Growth stocks ended 2024 at about the 80th valuation percentile—meaning that growth stocks are relatively cheaper than they were in 80% of periods since 1990.⁵

Could trade policy uncertainty throw the bull off course?

Finally, some investors have grown concerned with the noisy news cycle in early 2025, especially as it relates to international trade and tariffs.

One way to measure this news-cycle noise and uncertainty is with the Trade Policy Uncertainty Index, which measures how often terms related to trade policy and uncertainty appear in major publications. As of the end of January, the index was at its highest point in about 35 years.

It’s true that tariffs could be an inflation worry, although they might not be a concern for stock-market returns in 2025.

As the chart below shows, risk-adjusted returns for the S&P 500 were actually higher over the next 12 months, following periods since 1990 when trade policy uncertainty was in its top 5%.

Conclusion

It’s true that rising PE ratios have driven most of the advance in US stocks in recent years. Yet as was the case in past periods, the animal spirits driving the stock market could be a bullish signal for both returns and earnings growth.

In this type of market, looking past the news cycle—particularly as it relates to trade-policy uncertainty—may be an opportunity. This might be especially true for investors in cyclical sectors, which history suggests could outperform defensive sectors.