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Why Did the Major Auction Houses Abandon the Art Market’s Low End?

One of the most troubling art market trends of the last decade has been the stratospheric rise of ultra-expensive artwork while low to mid-priced works languish in obscurity. A great example of this phenomenon was the November 2017 Christie’s auction of the recently rediscovered Leonardo Da Vinci painting, Salvator Mundi. This work by that most celebrated of the Old Masters sold for an eye-watering $450.3 million, making it the world’s most expensive piece of art to date.

The bidding for the famous painting started at $100 million and rapidly rose in frenzied competition before finally settling at $400 million almost 20 minutes later. Now you might well be wondering, if the hammer price for the work was $400, then where did the $450.3 million final price come from? The answer to that, my friend, is the ultimate topic of this article.

The difference between the hammer price and the final price in an auction is called the buyer’s premium. The buyer’s premium is effectively a commission paid by the winning bidder to the auction house for its services. In the case of Leonardo Da Vinci’s Salvator Mundi, the buyer’s premium was a hefty $50.3 million.

Can you imagine it? Getting paid over $50 million for auctioning a single artwork? It must be nice work, if you can get it. And the world’s two major art auction houses, Christie’s and Sotheby’s, get a lot of it.

Of course, Christie’s did incur certain expenses associated with auctioning the Renaissance masterpiece. They had to pay for insurance, security, photography, authentication and marketing, in addition to the auction itself. But even so, I’m certain Christie’s made a substantial profit on this particular transaction. And this really encapsulates the prevailing business strategy of the world’s largest auction houses – conduct sales of the world’s most expensive artworks, charge a hefty buyer’s premium and then profit.

It didn’t used to be this way. Back in the 1980s and 1990s, both Christie’s and Sotheby’s had divisions dedicated to auctioning art at the lower end of the market. Christie’s affordable art subsidiary was known as Christie’s East, while Sotheby’s contender was called Sotheby’s Arcade.

Now when I use the term “lower end art” in this context, I am referring to works primarily priced between $1,000 and $5,000. But I understand if you chafe at the thought that spending several thousand dollars on art is considered “low end”, especially when you can buy some really compelling works for just a few hundred dollars or less.

These “low price” divisions were an attempt by the two largest auction houses to compete for first-time art buyers, interior decorators and amateur art collectors. These types of people were not lucrative, big-spending customers. But the auction houses hoped they could one day be cultivated into dedicated art lovers – with budgets to match.

Unfortunately, this enlightened philosophy went out the window when the global economic storm clouds moved in. Repeated financial crises in 2001 and 2008 hurt the middle class, damaging their ability and willingness to buy art. Instead of toughing out these poor business conditions for the sake of building long-term relationships, the major auction houses cut and ran. Christie’s closed its Christie’s East division in 2001, while Sotheby’s quietly wound down its Sotheby’s Arcade operations later on. Neither company currently accepts any consignment that is estimated to be worth less than $5,000.

But that wasn’t the only move the big auction houses made to distance themselves from the low and mid range of the art market. They have also engaged in an extensive series of buyer’s premium increases meant to discourage art collectors of more modest means. These fee increases occurred in 2008, 2011, 2013, 2016 and 2017 for both major auction houses. Right now, Christie’s and Sotheby’s levy an outrageous 25% buyer’s premium on purchases below $250,000 and $300,000, respectively.

If it seems suspicious to you that Christie’s and Sotheby’s tend to raise their prices in lockstep, you’re not alone. Both companies were accused of price-fixing by U.S. regulators in the 1990s and ultimately agreed to pay a $512 million fine to settle the allegations.

It is clear that the largest auction houses do not want to be bothered with anything less than the very best and, by extension, most expensive artworks. I believe there are a few major reasons for this.

First, the capital markets have become incredibly short sighted over the past 20 years. Corporate CEOs are expected to produce immediate financial results regardless of the business environment. CEOs who cannot or will not take the steps necessary to create prompt and robust profit growth are quickly ushered from their posts. This ironclad law of modern business management has been ruthlessly applied to the world of auction houses, even though it is slowly gutting the industry from within.

Next, although the buyer’s premium (expressed as a percentage) declines as the value of an artwork sold at the major auction houses increases, the absolute value of commissions on high priced works is too lucrative to ignore. The Leonardo Da Vinci Salvator Mundi painting mentioned earlier in the article is a prime example of this situation. Christie’s and Sotheby’s would much rather make a billion dollars in sales by auctioning a hundred different $10 million paintings than by selling ten thousand paintings at only $100,000 each.

Finally, the increasing economic bifurcation between the middle class and the extravagantly wealthy has meant that the money is in the high end of the art market. In fact, it is really in the ultra-high end of the market. Generally, only the very best pieces by the most renowned artists, mostly in the post-World War II and contemporary space, have flourished in this environment.

While I feel that the worm will one day turn on this trend, for now it is inescapable. The super-rich are buying more outrageously priced (and unconscionably ugly) art these days than ever before. And it means that, for now at least, the major auction houses are content to ride the wave, even though I suspect they will come to regret their snubbing of the middle class one day.

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Beware of Wall Street Con Men

More than a decade ago I worked at a miserable back-office job in the bowels of the financial services industry. But my true love was securities market analysis. I was keenly interested in stock investing and was always looking for new investment strategies. My specialty was options, a financial derivative that gives the buyer the right, but not the obligation, to purchase or sell a company’s stock for a fixed price within a certain period of time.

The thing I love most about options is that they are almost like Legos for investors. You can put them together in almost any combination you can imagine in order to build exactly the kind of investment structure you want. The best part is that you can easily determine the profit-loss characteristics of an options strategy before you invest a penny of your own money. Pretty great, right?

But options, like all potentially complex financial instruments, must be treated with respect. They are inherently levered derivative products that can just as easily magnify losses as gains. So it is best for investors to tread carefully in this space.

But in 2005 I felt like a mad scientist, feverishly slapping different option spreads, collars and overwrites together in unorthodox combinations in order to synthesize the perfect investment. One of the motivators behind my option-themed vision quest was the desire to create an investing strategy that could keep up with the then booming stock market, but with less risk.

And then I found it – the (nearly) perfect options strategy. I was ecstatic. This new options method boosted my projected investment returns by around 200 basis points, or 2%, per annum. That is a massive performance increase in the world of investing. Better yet, it increased potential returns while strictly controlling risk at the same time – a vitally important feature of any good investment plan.

But then I looked around and noticed something deeply disturbing. You can’t compete with Wall Street con men.

If an honest man painstakingly finds a way to boost investment returns from 10% to 12%, the stock fraudsters will claim to be able to get 15% or 20%. If an honest man discovers a new, low-risk investment strategy, the securities con artists will falsely say that their investments have no risk whatsoever. If an honest man invents a legitimate way to lower volatility in a portfolio without compromising returns, the Wall Street con men will purport to construct portfolios with high returns and no volatility at all.

Unfortunately, my cynicism surrounding the securities industry is borne out of experience. For example, back during the housing bubble in the mid 2000s, Wall Street con men in very expensive suits were selling shady CDO (collateralized debt obligation) and RMBS (residential mortgage-backed security) securities as substitutes for ultra-safe U.S. Treasury bonds. Investment advisors and portfolio managers stuffed these dubious AAA-rated CDOs and RMBSs into the investment accounts of unsuspecting victims all over the country.

And they were AAA-rated securities, but only because the rating agencies had been bribed; they were cut-in on the action by the Wall Street con men! In the end, huge numbers of these worthless CDO and RMBS securities went to zero during the Great Recession of 2008-2009.

Bernie Madoff is another poster child for the ubiquitous Wall Street crime syndicate. He ran a well-respected wealth management business that claimed to use options to achieve exceedingly high returns with unnatural consistency. In reality, Madoff presided over one of the world’s greatest Ponzi schemes, which totaled some $50 billion.

And he kept up the charade for an astounding 15 plus years until it spectacularly collapsed in late 2008. His victims, mostly non-profit charities, have only recovered a small fraction of their losses. As a final insult, Bernie Madoff had served as the vice-chairman of FINRA (Financial Industry Regulatory Authority), Wall Street’s self-regulatory agency!

There is a trend here. Whatever returns you can safely achieve in an investment will always be bettered by the Wall Street con men. A con artist will always tell you exactly what you want to hear in order to separate you from your money.

This revelation is especially pertinent in our current bubble market environment. Today’s Wall Street con men push stock investments in companies like graphics card manufacturer Nvidia, Chinese social media platform Weibo, or mobile app maker Snap. All of these firms trade at prices that will never be justified by future business results. But all that matters to smitten stock market investors right now is the siren song of easy profits.

The fact is that there is no such thing as a completely risk-free investment. Even such staid financial instruments as U.S. Treasuries and bank CDs have some miniscule risk associated with them. But there is a world of difference between the harrowing risks of today’s bubble stocks and the very modest risks of overlooked alternative assets, like fine art and antiques.

Buying bubble stocks is certain to make you destitute, but not before the Wall Street con men have paid themselves some very nice bonuses from your wallet first. On the other hand, fine art, antiques and other tangible assets will earn you a nice, steady return on your money, provided you do your homework and choose wisely.

I encourage you to take a step back and really think about the investments you have in your retirement and brokerage accounts. Steer clear of the “sure thing”, “can’t lose” investments pushed by glib Wall Street con men. They will tell you anything they think you want to hear in order to get your money. And when the inevitable financial crisis eventually arrives, they will disappear like thieves into the night, because they are thieves.

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Looking to Invest in Rare U.S. Coins? Read This First!

One of the tidbits of investment advice that you will hear again and again in the numismatic world is to only buy rare coins, particularly rare U.S. coins. These coins, usually low mintage semi-key or key date specimens, have had an impressive track record of appreciation over the past several decades. The underlying assumption is that any coin that has performed well in the past will continue to outperform in the future, as well.

Many rare U.S. coins have appreciated tremendously in value over the last 60 or 70 years. Specimens that only cost $25, $50 or $100 in the 1950s now routinely trade for thousands or even tens of thousands of dollars. A good example of this would be the 1909-S VDB Lincoln penny in AU-50 (About Uncirculated) condition. With only 484,000 minted, the 1909-S VDB is one of the major key dates in the extensive Lincoln penny series. In 1950, this coin would have only cost you about $10. By 2016, this same coin was worth around $1,250 – an impressive 7.59% annual rate of appreciation over the past 66 years.

The 1916-D mercury dime is another prime illustration of this phenomenon. Excluding overstrikes and other errors, it is the rarest coin in the mercury dime series, with a mintage of only 264,000. In 1950, a problem-free, 1916-D mercury dime in AU-50 condition would have run about $70, versus $9,000 in 2017. This represents a robust 7.52% annualized rate of return over the last 67 years.

So the conventional investment wisdom in rare U.S. coins is to look at the price data for a specific coin and see if it has had a consistent upward trend over the last few decades. If it has, you are golden; the semi-key or key-date coin in question is a buy. In contrast, if the price trend has been flat or inconsistent, then pass it by. This advice would apply to most common-date coins.

But there is a flaw in this reasoning. It doesn’t examine why rare U.S. coins have appreciated in value so briskly over the past several decades. So here is my theory.

Back in the 1950s, relatively few people collected coins, so prices were low. As the U.S. economy grew briskly over the latter half of the 20th century and the middle class became wealthier, more people began collecting U.S. coins, driving up prices. Values increased most rapidly for semi-key date and key date coins, because these were the scarce specimens everyone needed in order to complete their Buffalo nickel, Standing Liberty quarter or Walking Liberty half dollar collections.

But as the prices of rare U.S. coins increased, they began to price average, middle-class collectors out of the market. The 2008-2009 Great Recession was the coup de grâce for many collectors, who could no longer afford to build traditional date and mint collections for many U.S. coin series.

So if we think rare U.S. coins are going to be good investments in the future, we need to ask a couple questions. Who is going to buy these coins in the decades to come? And who can afford to buy these coins at prices substantially higher than they are at the present?

Let’s conduct a thought experiment to help us puzzle this out. Imagine we have two different coins. The first is a common date coin that costs $100. The second is a rare date coin that costs $2,500 – 25 times what the common coin does. Take a peek at the chart below and see what happens if we assume the common coin appreciates at an anemic 2% per annum while the rare coin compounds at a healthy 8% every year.

	Common	Rare
	Coin @ 2%	Coin @ 8%
Years	Return	Return
0	$ 100	$ 2,500
20	$ 149	$ 11,652
40	$ 221	$ 54,311
60	$ 328	$ 253,143
80	$ 488	$ 1,179,887
100	$ 724	$5,499,403

You’ll notice that after a century of 8% appreciation, our key-date coin would be worth almost $5.5 million versus just $724 for our common date coin! In this case, the rare coin would be valued at almost 7,600 times the common date coin. Attempting to inflation-adjust the price of the rare coin doesn’t help the situation much either. Assuming 2% average inflation over our hypothetical 100 year period, our rare coin would still be priced at a flabbergasting $759,000 in current dollars!

As you can clearly see, it eventually becomes mathematically impossible for a rare coin to continuously appreciate at a rapid rate. After all, outside of the occasional centi-millionaire or billionaire, who could afford to pay $5.5 million (or $759,000 in constant dollars) for a single key date coin?

Now there are a handful of unique or incredibly rare U.S. coins that have sold for unbelievably high prices. An example of this is the coin shown in the photo accompanying this article – the 1933 Saint Gaudens $20 gold piece. This ultra-rare coin was struck just as President Franklin Delano Roosevelt issued an executive order taking the U.S. off the gold standard and making private gold ownership for U.S. citizens illegal.

None of the 1933 dated U.S. double eagles had been released for circulation at the time of F.D.R.’s pronouncement and they were all supposed to have been melted down shortly afterwards. But a handful escaped the melting pot and found their way into the shadowy underworld of high-profile stolen art. Today, there are only 10 specimens in existence, with two of those coins permanently held at the National Numismatic Collection in the Smithsonian Institute. The only 1933 U.S. double eagle gold coin ever legally sold brought a stunning $7.59 million at a 2002 auction.

But ultra-expensive, rare U.S. coins like the 1933 $20 gold piece are exceptions that prove the rule. They aren’t simply key-dates or rare; they are breathtaking pieces of numismatic history. They all have intriguing stories behind them and there are usually no more than a handful of extant specimens. This holds true regardless of whether it is the 1794 Flowing Hair silver dollar that sold for $10 million or the 1913 Liberty Head nickel that brought $3.17 million.

The fact is that shockingly few rare U.S. coins enjoy the unique combination of history, scarcity and mythology necessary to be considered numismatic legends. Your average semi-key date or key date rare U.S. coins, like the 1909-S VDB Lincoln Penny and the 1916-D mercury dime, will never command multi-million dollar prices (barring significant inflation). This means you just can’t throw your money haphazardly at “rare” U.S. coins at any price and expect to see good investment results.

A lot of these key-date coins have already had great runs. The 7% to 9% returns that many rare U.S. coins have seen over the last 60 to 70 years are not reproducible. They have already had their time in the sun. I cannot make predictions about near-term performance, but time is not your ally when you pay tens of thousands of dollars for a rare U.S. coin that isn’t truly exceptional in some way. Rarity, by itself, isn’t a sufficiently compelling attribute to drive high numismatic investment returns.

Rare U.S. coins are really constrained by a concept known in finance as the law of large numbers. It is relatively easy for something that costs $100 to appreciate rapidly – it might eventually become $1,000, which is expensive, but not ridiculously expensive. But when something starts at $100,000 or $1,000,000, it has a much harder time compounding at a high rate because no one can afford the final price.

Now, I’m not saying that rare U.S. coins are universally bad investments or that you should buy common date coins because they are destined to “catch up” to scarcer coins in terms of value. I’m simply stating that the excellent buying opportunities that prevailed in the 1950s for key date U.S. coins are over. Instead we should look forward and ask ourselves “What $100, $200 or $300 coin today, will be worth $10,000 tomorrow?”

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A Failure of Investment Imagination

I regularly read a website about overpriced West Coast real estate called Dr. Housing Bubble. The site had an interesting exchange in the comments section of one of its recent posts. One commenter encouraged people to contact their congressional representative and ask him (or her) to ban the foreign purchase of U.S. real estate. A regular commenter then responded with this:

First of all I think any law like that would be thrown out by [the] courts. If Trump can’t ban radical Muslims from entering the country, good luck banning rich Chinese from buying homes.

Second, it is ridiculous to tell foreign people who want to bring money and invest it here “sorry we don’t want your money”. Actually ridiculous isn’t the right word…downright insane is a better description.

I wanted to highlight this quote because I feel it is emblematic of one of the greatest investing conceits of our age – a complete failure of investment imagination. Investors gripped by this dread disease cannot fathom the possibility of a world that is significantly different than the one we currently inhabit. To them we have reached the end of investment history, where current investing trends, tax laws and economic policies must inevitably persist forever.

But a failure of investment imagination can be hazardous to your wealth. In fact, we are already beginning to see the slow disintegration of the old financial regime as economic pressure ratchets ever higher.

For example, in August 2016, the Canadian city of Vancouver instituted a 15% transaction tax on foreign real estate buyers. In April 2017, the entire province of Ontario followed suit with a similar surcharge. New Zealand has just instituted an even more radical policy than Canada, by completely banning the sale of existing homes to foreigners.

To believe that California real estate is somehow immune from these global developments is unrealistic. Yet this Dr. Housing Bubble commenter, along with hordes of property buyers, thinks that U.S. real estate policies cannot possibly change. And while this particular failure of investment imagination is about real estate, it is obvious that a similar mindset is ensconced in all asset classes.

In some ways this is a very natural, very human reaction to the post-Great Financial Crisis investing landscape. For the last decade, markets of every description – stocks, bonds, real estate – have gone nowhere but up. This has made investors complacent and entitled. They cannot imagine a different world, because today’s world is the one they are getting rich in. And they never want to stop getting rich.

The future, however, is likely to be far less forgiving than the present, particularly in capital markets. The metaphorical ground underneath our collective economic feet is likely to shift in a profound, and possibly disturbing, way. Due to a widespread failure of investment imagination, few people are prepared for this brave new world.

What changes will take place in the economy over the next few years? To be honest, nobody knows. The world’s central bankers are currently conducting the largest, most ambitious monetary experiment in human history. As a result, we are in completely uncharted economic territory, and anybody who says otherwise has an agenda. However, I do think there are a few events that we can reasonably assert will happen in one form or another.

First, I think it is highly likely that what has worked for investors over the past 10 years will stop working rather suddenly. Risk-oriented paper assets, like stocks, REITs and high-yield bonds, which have marched relentlessly higher over the past decade, will abruptly lose favor. This will be a tremendous shock to professional money managers and financial advisors, who have built their portfolios around these traditional investment classes.

Second, it is clear that the world will become increasingly localized as globalization at least partially reverses. Money and goods will not flow across borders as easily as they once did, and, in certain situations, they may not flow across borders at all. Neither major corporations nor mom and pop investors are prepared in the least for this eventuality. I detail this concern at greater length in an article titled “Hard Assets in a World of Capital Controls“.

Finally, I believe the future will see a wave of corporate defaults as over-levered companies finally hit the limits of financial market credulity. This will undoubtedly catch large numbers of sanguine investors off-guard. Losses will be steep and the damage will be distributed across a wide range of historically “safe” investment strategies.

The flip side of today’s ubiquitous failure of investment imagination is that alternative assets, like bullion, fine art and antiques, have generally been overlooked. The recent performance of these tangible assets has been rather modest compared to market darlings like crypto-currencies and technology stocks. But then again, you won’t wake up one random Monday morning to discover that half the value of your bullion stash has been wiped out over the weekend.

This nightmare scenario, where the bid for stocks and bonds dries up suddenly, is called a discontinuous market. And it could cause the major market indices to gap down by 10%, 20% or even more in a very short period of time – perhaps minutes. Stop-loss or trailing stop-loss orders which would normally protect your brokerage portfolio would actually be detrimental in this situation, as they would force you to sell into the teeth of the panic.

These dark circumstances in which the previously unthinkable suddenly becomes fact, are, unfortunately, not just possible, but probable. They are the natural side effects of highly distorting central bank policies that have gutted the middle class while simultaneously creating a new gilded age for the ultra-wealthy. As frightening as this bleak future sounds, there is a way to protect yourself. Undervalued hard assets represent a great opportunity to hedge market risks. Don’t let a failure of investment imagination hobble your portfolio.

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