The State of the Art Market – An Analysis

One has to imagine the players were sweating bullets after the November 7th evening sale of Impressionist & Modern Art at Sotheby's failed to make the low end of the pre-sale estimates. What a difference a week made, the Post War and Contemporary Art sales came in strong, and everyone seemed to be breathing a sigh of relief.

This feeling of well being may be premature, as the auction markets are indicating that a topping process has begun. The rate of price appreciation peaked in 2006 and is showing signs of slowing, indicating increasing resistance on the parts of the new buyers to pay "any price" in order to participate. This is not to say there were no new price records set, to the contrary this was the case, but at a market peak, price records are the norm not the exception.

All this talk of money is enough to make one dizzy, it is confusing to say the least. It has less to do with the art being sold and more to do with speculation on a volatile commodity in a bullish price environment. So, I am going to take off my beret and have a look at the art market as an investment vehicle, as a commodity, a pound of flesh to be bought and sold.

"Capitalism I & II," 2006, Oil on Aluminum,
24 in x 37 in / 61 cm x 94 cm overall, 2 panels

Follow the money. Last year we saw several paintings change hands at prices which would have been unimaginable only a dozen years ago. Who would have thought paintings, and not just one painting, several, would sell in excess of $100 million dollars? What is happening?

In my previous musings on the art market I have mentioned the notion that we are living in an unique era, one that has seen an unprecedented creation of wealth world wide. The internet boom, the revolution in information technology, had an effect on the US economy unlike anything since the build out of the railroads at the turn of the last century.

In the developing countries, especially since the collapse of Communism, rapid economic growth has occurred in both the industrial and technological sectors. Without breaking down the details, it is apparent that personal wealth rapidly expanded at the end of the twentieth century.

The last bear market in art occurred in the early 1990’s and the auction markets that followed it into the turn of the century were not making headlines, prices were behaving more or less normally. Around 2002, a change seem to take place. After the bursting of the internet bubble, art was promoted as alternative investment, one that could perform on a par with the stock indexes. Whether or not this was true didn’t matter, it became fashionable to collect art. The result was an influx of capital into the art markets, it appeared to pick up steam around 2003 or 2004 and prices jumped.

The Range Shift. This is an important concept which may help explain some of the behavior in the art market. Markets may trade in an orderly fashion, typically range bound, for a number of years and then suddenly move higher, a lot higher. Typically, the participants who understood the previous range bound pricing, are caught flat footed, betting that the new market move is unsustainable, and that prices are "too high."

A good example would be the Dow Jones Index which made the breakout from the old sub 1000 range and made the sprint to 10,000. This move was accompanied by the doubters who perpetually suggested the indexes ‘had’ to return to the 1000 level, next week, or next month, whatever, they were wrong. This type of price change is what I call ‘range shifting,’ and it can occur without any apparent fundamental reason at the start.

This is what I believe occurred in the art market over the last five years. Prices increased suddenly, across the board, and rising prices draws in new buyers. New buyers push the prices higher, and the speculators join the game.

I believe art market prices have experienced a range shift, a ratcheting higher in prices, which is much greater than what we would consider normal price appreciation for artworks.

This is a once in a generation occurrence, the range shift is over, at best some market sectors are playing catch up but the rapid expansion in prices cannot continue going forward.

For example, let us look at Hugh Grant’s sale of Andy Warhol portrait of Elizabeth Taylor, "Liz," for $23.5 million. In the previous post I inferred that I thought this was an astute move. (For the record, I used publicly available prices, didn’t subtract the commissions, etc. It doesn’t matter, this is just a rough example.)


The Buy and Sell Reportedly, in 2003 Mr. Grant paid $3.5M (million) for the Warhol "Liz." This is just about the time I am suggesting the price range shift began. At the Christie’s auction last week it was sold for $23.5M, or roughly five times what he paid only 4 years earlier.

What’s it worth? A reasonable expectation for the rate of appreciation of an asset class like art works might be close to expectations for equities. The compound annual price appreciation for the Dow Jones Industrials, from the 19332 low to the 2007 high, is approximately 8% per annum. Since the bull market began in 1982, this figure is a bit higher at 11.4%.

Using stock returns as a benchmark, "Liz" should have been worth in the vicinity of $5M to $6M today, this range is calculated using 12% [DJIA] and 20% [NASDAQ] as a growth rate. Since $23.5 million is substantially above the expected price range of $5M to $6M we can either conclude their was a bidding war or that some other event is affecting pricing. If this sale was an isolated incident, then we could ignore the results as a statistical outlier. "Liz" was not an outlier, a number of paintings, across the board have been trading at significantly higher prices than normally would be expected.

This is the range shift, it appears that art prices got an additional zero as a millennium present. The new ten thousand is a hundred thousand, but not a "million" as some wag offered up.

Range Shift Confusion One of the interesting characteristics of the equity markets is that whenever there is an abundance of the participants in agreement, they tend to be wrong. If 65% of the participants think the markets are headed higher, it is usually a good indicator that a top is near. In other words the consensus is usually wrong. By the time everyone is in agreement, has read all the ‘news’ and understands ‘why’ prices should move higher, their is no one else left to sell to, poof!

I suspect many readers would like to think the art market is different, it is not. The art market behaves in the same way as other markets which are subject to the psychology of ‘group thinking.'

Participants tend to doubt the initial price increases. They tend to recognize when the market is hot. They tend to make straight line assumptions, tomorrows prices will behave approximately like today’s. They tend to increase in numbers near the market peak. There has to be someone to sell to, someone who is more optomistic than you, maybe they will be right, usually not.

It is the point about making straight line assumptionsabout price behaviour which is about to cause severe problems for the participants who are buying and selling art as a speculation. In particular for those new to the game of speculating on artworks may discover when it is time to "flip" they flop.

Buying at the top My stock player friends have a word for traders who buy at the top, they call them "investors." We might call failed speculators in the art market, "collectors."

Looking at the "Liz" price. From purchase to sale, the price of this painting appreciated at a compound rate of 61% per year.

This is a phenomenal rate of return. There is no way the buyer of this painting could ever experience the same rate of return, by 2015, at 61% per annum, the selling price would be $1,000,000,000 (a trillion bucks).

Suppose the buyer is only hoping to double his money. The buyer will calculate that if prices continue firm and the average return is about 8% per year, it will take seven or eight years for the painting to double in price to $47M.

While this may seem like a reasonable investment decision, it is based upon a faulty assumption which ignores the range shift principle. The range shift principle only implies that prices can move abruptly into a higher price range. Barring hyper-inflation prices will tend to revert to the mean, the normal expected price over time. Current prices are well above the mean, either they collapse or move sideways in order to normalize.

The green line in "Liz" chart above is the normalized 8% price growth curve, starting from $3.5M. Over long periods of time one would expect the price of "Liz" to approach this value. This means the new buyer should expect to hold the painting for at least 20 years in order to realize a 100% return on his initial investment. On an annualized basis, ignoring ownership expenses, the real return would be only 2.88% per annum. It is a lousy investment.


The Basquiat painting, "Black Figure" This work sold at Christie’s for $9.87M. I made an unfounded assumption that one might have been able to buy this painting in 1982 for $50,000. I’ve normalized all the curves to this price.

Based upon my hypothetical purchase price of $50K, the annualized price growth is 23.5% per annum. This is high but surprisingly close to the NASDAQ growth rate from 1992 to 2000, which was about 20% per annum.

While I believe a $10 million tag is a bit steep for any painting, I suspect the Basquiat was a better investment because the range shift was smaller, closer to $2M to $3M, rather than $18M for "Liz". Since the range shift is a potential price risk and definitely a potential extension of the holding time risk, a smaller value is more desirable.

Drawing Conclusions The Van Gogh buy-in is probably a good indication that the market has peaked in the historical sector. I believe that artworks over one hundred years old have been more thoroughly analyzed, that conniseurship and the quality of the work are more important considerations.

Vincent van Gogh, "The fields" (Wheat fields), 1890
Oil on canvas, 19.7 x 25.6 in. / 50 x 65 cm.
Sale Of: Sotheby’s New York: 11/7/07 [Lot 9]
Estimate 28,000,000 - 35,000,000 US$
Sold For BOUGHT IN

If we consider the psychology behind the failure of the Van Gogh offering, what can we conclude? First we can suggest that the pre-sale estimates were set to high and as a result the initial bidding momentum stalled, then stopped entirely. The obvious solution to this problem would be to lower the pre-sale estimate. This has the implication that prices are "soft" and that for the next auction the pre-sale estimates will probably be more conservative.

It is better to risk a slightly lower sales price, betting on good bidding momentum, than take the chance a greater number of artworks will be bought-in. If the participants see an increasing number of artworks failing to sell, they will become tighter with their bids, and prices will decline.

The damage has already been done with the resultd from recent Sotheby's sale of Impressionist & Modern Art. In spite of the very positive results for the following sales, the seed of doubt has been sown and both auction houses will think twice when making the pre-sale estimates. This is a psychological negative for prices and I believe it is also a leading indicator for the future.

The final factor, the major factor, is still the US economy. The current credit problems have the potential of become more difficult to correct. This may drag the economy into more than just a shallow recession I initially expected. So far the FED has cut interest rates another 1/4 point, but I think it will take more than that to solve the problem. It’s dicey at the moment.

Next, How is all this money stuff affecting art? Do we care?