The Orange Balloon Dog

by Don Thompson

  There is tremendous speculation for the work of a few emerging artists, another signal of a bubble. Collectors chase these works with the hope of flipping them for a quick profit. The focus on emerging artists is partly from lower investment costs, partly because it is easier to establish (or pretend there already are) waiting lists and pent-up demand. Lucien Smith’s 10-foot-tall (3-metre) painting of a “Winnie the Pooh” landscape, made by spraying paint from a fire extinguisher, sold at Phillips New York in 2014 for $389,000. Two years earlier, while Smith was still an art student at New York’s Cooper Union, the same work sold for $10,000. In the interval, much of his output was purchased by speculators. Private dealer Alberto Mugrabi has said he owned at least twenty-five Smith works.

  For five years starting in late 2009, the hope was that the Chinese or Russian markets would purchase Western art and prop up prices. This was a reasonable expectation. About a third of China’s wealth and 25 percent of Russia’s is in the hands of 1 percent of families in each country. China has more dollar billionaires than either the US or Western Europe. The formation of a super-rich oligarchy, first in Russia and then in with the fuerdai (second-generation children of the ultra-rich) in China, meant that there were many people without much experience in how the upper class spend, invest or protect their wealth. And there were many art advisers trying to help them spend.

  This is a new version of an old idea. Thorstein Veblen in his 1899 book The Theory of the Leisure Class argued that wealth would produce conspicuous consumption. And this would, dealers hoped, result in the new Chinese and Russian leisure classes requiring ever-increasing amounts of Western art.

  As it turned out, this had limits. After Chinese leader Xi Jinping implemented his anti-corruption drive with a crackdown on conspicuous spending and on “gifting,” China’s booming high-end art market shrank by a third in 2014 and a further third in 2015. (It rose a bit in 2016.) Russian demand for Western art dropped by half after President Vladimir Putin’s “invest here” edict and later with the drop in the value of the ruble. Billionaires in both countries, along with newly rich from the Arab states, India and Africa, came to prefer investing and parking their families in high-end Western real estate owned through offshore entities.

  The real question is why there is so little acceptance that there will be an inevitable price correction for high-end contemporary art. A partial answer comes in the findings of behavioural economists, who argue that our brains are hard-wired to make bad decisions about the near future. The most significant behavioural quirk is that we all expect that the future will resemble the recent past, that change will occur only gradually. It is too hard to analyze the implications of the extreme economic and political events we read about, so we generally ignore them. Consider the slump in oil prices that began in 2014, the commodities glut, the collapse of the Russian ruble, the slowing of the Chinese and Brazilian economies and art markets, the six-sided war in the Middle East, terrorist attacks in France, Belgium and the us, or currency volatility as countries sought competitive devaluation. Most auction specialists and dealers ignore these and offer a single forecast for future art markets. This single forecast is their response to wanting to believe that the future will be like the recent past. If change comes, it will be gradual and there will be time to react.

  For art and other investments this often means that we buy when the market is rising, and we rush to sell when it is falling (when we should be buying). Research shows that investors are four times more likely to sell a stock that has risen 60 percent than one that has been flat. I have no doubt this is true of art held for investment purposes.

  Some art insiders seem to view demand for art with the implicit assumption that business cycles no longer matter. The godfather of that dogma is Tobias Meyer, when he was chief auctioneer at Sotheby’s. Meyer argued in 2006 that for the first time since 1914, art was in a noncyclical market.109 His logic was that any downturn in US demand would be offset by new collectors from Russia, Asia, Latin America and the Middle East.

  Meyer made an avoidable error: he equated the top 5 percent of the market, which had been globally integrated, with the remainder of the market, which was still predominantly national—Brazilians buying Brazilian art, Germans buying German art. A broad, no-longer-cyclical statement should itself have created concern that a speculative bubble loomed.

  The bubble was there. Price levels in contemporary art auctions in the US and UK, and in Hong Kong, Beijing and Moscow all cratered in the second half of 2008. Billionaires were, as Meyer also surmised, largely insulated from the recession. Those who continued to buy sought and received high discounts.

  Christie’s then chairman Brett Gorvy then offered another version of the Tobias Meyer outcome. “They are making billionaires faster than they are producing iconic works of art.” But his underlying assumption of unending lust for Western contemporary art by new billionaires, wherever situated, may also be fallacious. It implies that future demand by the wealthy will be fundamentally different from that of the more cyclical past. It does not require much of a change in confidence or tastes to produce a dramatic shrinkage in Christie’s estimate that there were about 150 people in the world who might bid for expensive art.

  The irrational exuberance of the stock market before the crash of 1987, of the real estate market before 2008 and of the high end of the contemporary art market in 2016 reflects another behavioural economics phenomenon—call it the momentum effect. Groups of people, at an auction house luncheon, an art dealer reception or a private club dinner, inhale the preaching of unlimited promise of the art market (or of an individual artist) offered by the most opinionated person in the room. Group members nod agreement. To remain out of the market when everyone else is doing so well seems dumb, so you buy. Your subsequent recounting of short-term profits encourages others to follow.

  Irrational exuberance in a rising art market is fed by auction house efforts—like those of Tobias Meyer—aimed at maintaining the impression of a boom. Prior to an auction, reserves are firmed up by guarantees or irrevocable bids. Artists like Jeff Koons are featured in auction publicity and in post-auction announcements. There are low opening bids, chandelier bids to build excitement, and an auctioneer creating tension among the last few bidders. Recall the Balloon Dog (Orange) auctioneer’s comment “Don’t let him have it.” My favourite not-very-subtle auction bidding nudge was something that Amy Cappellazzo mentioned while relating her phone conversations with clients during an auction when she was still at Christie’s. She said she tried to squeeze them. “I say, ‘Listen, it’s like you saw the most beautiful woman in the world at a bar, and you didn’t ask her for a drink. What a loser!’”110 That would certainly nudge me to bid again.

  The phenomenon called anchoring also acts to maintain art prices during flat periods. Anchoring is one of the most powerful biases in economics. A consignor attributes a minimum value to an artwork based on what she paid for it. The collector, call her Sarah, refuses to part with her Damien Hirst butterfly-wing collage for $2 million because she paid $3 million—so that is what it is “worth,” that is her anchor price. She holds to this concept even in the face of evidence that no one seems interested in purchasing at this price.

  Sarah offers her Hirst to an auction house. The auction specialist is reluctant to accept it with a $3-million reserve, but even more reluctant to see it go to a competitor. The specialist tries to convince Sarah to agree to a $1.5-million reserve and a $1.5-million estimate. This is a lowball approach to consignor estimates, intended to attract bidders. It is the auction house’s preferred strategy. The logic is that during the bidding process, those seduced by the low estimate become caught up in the endowment effect, and commit to progressively higher bids than they intended when bidding began. For the auction house, low reserves and estimates produce a high sell-through rate, and a high sold-over-estimate figure.

  Sarah holds firm, insisting on her $3-million reserve, thus a $3-million to $4-million estimate. Th
e high estimate range is not what the auction specialist wants, but it has an underlying logic. A risk-adverse bidder with no basis to judge the estimate may choose to bid to the low estimate or to the halfway point between low and high.

  Having “no basis to judge” is another form of information asymmetry. Most potential bidders have no way of acquiring the same information the auction house specialist has about the work and its history. Failure to understand information asymmetry causes bidders to think that an auction is inherently self-regulating, that the amount other bidders offer is a reliable signal as to value. Bidders also assume that an auction house would never intentionally over-estimate value for fear of reputational damage. (That fear of reputational risk is what Volkswagen owners assumed about that company before the 2015 exhaust-rigging scandal. In a 2016 agreement to settle a class-action suit, Volkswagen agreed to pay each US owner of its problematic diesels $20,000 for loss of value and to compensate for angst caused by the company’s misleading claims, and $2.1 billion to 105,000 Canadian owners.)

  The auction house takes the consignment and tries to compensate for Sarah’s anchoring bias in two ways. One is to emphasize in auction promotion the past prices that Hirst works have achieved. Past prices are relevant because they imply to a hesitant bidder that there is some component of artist value that is known to others.

  It is not only small-scale collectors for whom anchoring becomes significant. Consider New Yorker Jose Mugrabi, who with his sons Alberto and David have the biggest Warhol collection in the world outside the Andy Warhol Museum in Pittsburgh. The family has said there are at least eight hundred works, with some outside estimates higher. Beyond Warhol, the Mugrabis own three thousand works, including one hundred or more by each of Hirst, Jean-Michel Basquiat, George Condo and Tom Wesselmann. The family members collect, but are also private dealers on a massive scale, buying and selling works through dealers and in auctions.

  Mugrabi purchases and sales are carefully tracked by other art investors. The market anticipates that the Mugrabis will hold rather than sell if there is temporary market weakness. They will accept earlier “valuation” as an anchor. But what happens if the Mugrabis, for whatever reason, decide to sell off Warhol, or Hirst or one of their other artists-held-in-bulk? The anchor they were expected to observe now disappears. Trade papers would all have a version of the same headline: “The Mugrabis Are Selling, the Mugrabis Are Selling.” When insiders are seen to be dumping art, particularly when there is concern about a looming bubble, regular investors get nervous. The easy prediction is that other collectors-in-bulk—Peter Brant or S.I. Newhouse Jr.—would immediately decide to sell, as happens in financial markets when there is a disruption.

  In the art market this can be even more disastrous than in financial markets. When the market for an artist’s work is seen as illiquid, it is hard to sell at any price. No collector wants to be last out the door, or the first to get rejected for inclusion in the next auction catalogue.

  How do you take all this into account and still game the art market and its looming bubble? First, have this tattooed on your arm: “The past is not a guide to the future.” Then write down a range of possible future outcomes for the art market, and beside each, the sequence of events that would be required for each outcome to occur. Consider major economic events. How likely are we to repeat the stock-market crash of October 1987, the Asian collapse of the late 1990s, the crashes of the real estate and art market in 1990 and 2008, and the worldwide but short-term stock-market slump of 2015?

  You might think that these were low-probability events, that they can be ignored. But ignoring such events is another cognitive bias that affects investing, an understandable confusion of the concepts of probability and risk. These are different things. Risk is the probability of an event times its magnitude. What is seen as a low-probability event—the mortgage crash of ’08—was disastrous because its magnitude was huge. Do you want to totally ignore the probability of a 30-percent slump in the North American real estate and stock market? Think of other examples where an investor has been blindsided by a very low-probability event.

  The bias toward optimistic outcomes is seen in many other facets of life. Various surveys show that between 5 and 10 percent of heavy smokers think they might develop cancer; 90 percent or more are confident they will not. Fifty-eight percent will develop cancer.

  We may accept that a negative event might occur, but prefer to assume it will take place a few years in the future—certainly not next week. In 2006 and 2007, every US real estate economist knew there was going to be a peak in resets on adjustable-rate mortgages in 2008 and 2009. They knew that because 2005–06 was the peak time for sales of homes with three-year, low introductory-rate mortgages that would reset after that period. It was hard to avoid the conclusion that there would be a mortgage crisis and resulting housing price slump that would impact the whole economy, likely beginning in 2008. Many observers did avoid it with the hope that something good would happen to minimize the impact, or that others would not notice what was happening. Investors kept investing in real estate and stocks (and art) through 2008.

  After the “future outcomes” exercise, here is a second. Assume you have spotted a desirable work of art that is available for $10 million. Should you buy it as an investment? Say you want to achieve a 15-percent return on that investment, over and above costs. Work backwards from your target. What conditions are needed to achieve this 15-percent figure over a five-year period? You would have to net $20.1 million, so you have to gross about $24 million on resale after five years, to cover commissions, insurance, the cost of capital, and still earn 15 percent.

  What do you believe, not only about the future state of the economy but also about the demand for art and the demand for this particular artist and period? Try to develop a range of likely scenarios that would permit that $24-million sale. Look at market conditions over different five-year periods in the past. Do you need a particularly good five-year period, or would an average period be enough? You obviously can’t do it with a bad one. What this exercise does is force you to abandon the easy bottom-up analysis, like simply asking your dealer or another collector what they think about the future.

  A third exercise is to write a pre-mortem; this is a retrospective that you pretend is written in the future. You are writing five years from now, to explain the failure of the investment under consideration now. The pre-mortem forces you to commit to a considered analysis and listing of what could happen. If you don’t get around to doing the pre-mortem, do a post-mortem after an investment disappoints. What did you not consider? Why should you have foreseen this outcome?

  In either the top-down analysis or in a pre-mortem, don’t focus on a single descriptor: “very good,” “good,” “not so good,” “very bad.” Most successful planners use at least two variables when thinking about the future. The variables must be independent of one another (e.g., “continued acceptance of current Brazilian artists” and “whether my job will continue to pay big annual bonuses”). If the variables are related (e.g., “my bonuses” and “the state of the economy”), in reality you are considering only one variable.

  Think of the future demand for a work of art as at least somewhat related to four different variables: the strength of the national (or world) economy; the continued demand for art as a positional good; the desire for art as an investment good; and the demand for the work (or style) of a particular artist. Four variables produce twenty-four possible outcomes. Only one of these is the status quo. More than half the twenty-four possible outcomes will be negative for your investment in a particular artwork.

  Many of the variables are determined by almost unpredictable events: an artist being taken on (or dropped) by an über dealer; a newsworthy backstory created for the art or artist; or fortuitous luck. Luck or randomness does play a huge role. The best example I know involves Leonardo da Vinci’s Mona Lisa (1503–16) in the Louvre, the best-known painting in the world. It is undoubtedly a marvel
lous work, but why the best-known? Prior to 1911, Leonardo’s two best-known works were The Last Supper (1495–98), now at the Convent of Santa Maria delle Grazie in Milan, and The Virgin and Child with St. Anne (1503–1519), also at the Louvre.

  Mona Lisa was stolen from the Louvre in 1911 by maintenance worker Vincenzo Peruggia, an Italian who kept the painting in his apartment for two years before trying to sell it to the Uffizi Gallery in Florence. (Pablo Picasso was high on the investigators’ list of suspects, but was cleared.) There was continuous publicity, first around the theft, then around Peruggia’s arrest. Mona Lisa was reproduced on the front page of many of the world’s newspapers and magazines, with extravagant descriptions—which the Louvre provided—of its importance and value. The work vaulted from “a top-ten Leonardo” to its current status.

  Back with my third exercise on writing a pre-mortem, it can be made fun. Try giving the scenarios catchy names—“disasterville” for the worst scenario and “nirvana” for the best, for example. Moderate outcomes can be “deep embarrassment” and “barely tolerable.” For a more creative twist use music titles—“Gloomy Sunday” and “Time to Say Goodbye,” or “I Lost My Heart to a Starship Trooper” and “Beautiful.” And yes, I am a Sarah Brightman fan. Then figure out the risk you are taking, and multiply the probability of failure by how important that failure would be to your total investment portfolio.

  The hardest part of my art exercise is the final step, estimating future demand for the work of a particular artist. In the art market, this means choosing the artists or at least the schools of art that will be in favour five years hence. You have to guess what artworks other people are guessing that others are guessing will be in favour. Dealers or collectors who insist they know that particular artists (whom they represent) will be more valuable five years hence are guessing what collective wisdom will conclude in the future.