Overconfidence Galore - Vikram Mansharamani
Anyone who has witnessed a live auction in which bidding far exceeds preauction estimates or sets a new world-record price understands that there is something curious in the air—something electric, something indescribable, something magical. I believe that “something” is confidence, perhaps even overconfidence. Consider the stock chart of Sotheby’s, shown in the following figure, which has proven useful as a bubble indicator. A quick scan of the list of the world’s most expensive paintings finds numerous chronological clusters: 1988–1990, 1997–1999, 2006–2007, 2011–2012 and 2015, and then again in 2017–2018. Not surprisingly, these clusters are associated with (relative) highs in the price of Sotheby’s stock. New highs in Sotheby’s stock price are an important indicator of overconfidence and bubbly conditions.
At each of these times, confidence was running extremely high. In the late 1980s, for instance, Japanese art buyers domineered the market for high-end art and were responsible for numerous world-record prices. Sotheby’s stock price peaked months before the Nikkei began a long decline. Likewise, the 1999 peak in Sotheby’s stock price is associated with the (irrational?) exuberance that telegraphed the tech bust. Although the buyers were different, the dynamics in 2007 were not different. Beneficiaries of easy money (hedge fund and private equity executives, among others) bought art at world-record prices, driving Sotheby’s stock price to new highs. Again, the stock’s peak telegraphed the global financial crisis. The 2011–2013 peaks were driven by Chinese and emerging-markets buyers, possibly telegraphing a Chinese and emerging-markets slowdown. And most recently, Middle Eastern buyers have been setting new world-record prices, including $450 million paid for Salvador Mundi, a painting by Leonardo da Vinci, which sold at auction in 2017. Some of my thinking about the usefulness of Sotheby’s in predicting bubbly conditions was described in an article in The Atlantic by Derek Thomson, “The Art of Bubbles: How Sotheby’s Predicts The World Economy.”
Since that piece was published, many have asked me to clarify why Sotheby’s stock price seems to telegraph bubbly conditions. I’ll begin my answer with a question: might the relationship between Sotheby’s stock price and bubbles merely be a coincidence? I personally do not think so, because in my eyes, Sotheby’s is a leading indicator of leading indicators of confidence. Specifically, three layers of confidence stacked on each other can be seen in the firm’s stock chart: (i) buyer confidence, (ii) appraiser confidence, and (iii) investor confidence. Unlike the actual prices of art—which may be a reflection of buyer confidence—Sotheby’s stock price is less subject to the whims of individual buyers or the uniqueness factor associated with specific works of art. Not surprisingly, those who set new world-record art prices tend to be those who have substantial personal resources—meaning they are usually very, very rich. In short, those who pay $100 million (or more!) for a painting usually have much more than $100 million in net worth; such buyers are likely to be billionaires with significant corporate interests.
Because of this connection between art buyers and corporate leadership, art markets serve as a useful indicator of corporate and global confidence. If the CEOs of major companies begin to see clouds on the economic horizon (through their corporate capacity), they are likely to scale back on their personal art buying. The inflection point when executives convert from aggressive to reluctant bidders is very unlikely to result in world-record art prices. It should not be surprising, then, to note that corporate M&A activity had recent relative peaks in 1999–2000 and 2007. (There wasn’t a new M&A peak in 2011 in terms of transaction value, due in some part to the extended nature of the global credit crunch.) Incidentally, the data for 2018 shows the volume and value of transactions at historically elevated levels. Time for caution?
An additional layer of confidence is important to consider: auction house appraiser confidence embedded in pre-auction estimates. As new record prices are set, appraisers themselves begin increasing their estimates of what future sales should achieve. Imagine that you are an appraiser of Chinese artifacts, and a vase estimated to sell for between $800 and $1200 recently sold at auction for $18 million (true story!). Might you be inclined to raise your estimate of other Chinese artifacts? Higher prices yield higher estimates, which yield higher prices—until they don’t. Closely related to this appraiser confidence is management confidence. In the past, Sotheby’s management grew so confident in their appraisers that they began guaranteeing prices to prospective sellers.
The result was an increase in “inventory” owned by Sotheby’s at precisely the time that the market for such art was cooling rapidly. In addition to buyer confidence and appraiser confidence, a third form of confidence is captured by the price movements of Sotheby’s: investor confidence. Because Sotheby’s stock is itself an object of investor bidding, it is a manifestation of investor perceptions and analyst estimates. As auctions go well, analysts raise earnings estimates. Higher estimates make the stock appear less expensive, drawing investor interest. Relatedly, the investor relations function at Sotheby’s exhibits variable confidence as the stock progresses and the underlying business results become obvious, thereby affecting analyst estimates.
At the time of this writing, Sotheby’s stock had jumped to an all-time high on news that it was being acquired. While this may be a sign of overconfidence in an overconfidence indicator, the Sotheby’s stock price before the acquisition was falling…. What should we make of it? Is it telling us that the Middle East may prove to be a new source of potential uncertainty and economic disruption? Should the fact that Saudi Arabia is spending gigantic sums on defense concern us? What about the attempt to transition the economy off of oil? Or the fact that the Kingdom is trying to sell its crown jewel (Aramco)? It seems to me that it would be prudent to take a more risk-averse stance vis-àvis investing in the Saudi market, despite the global investor charm offensive that’s currently underway.
At the end of the day, spotting bubbles is at best a probabilistic exercise and requires multiple confirmatory data points before we can say anything with conviction. Certainty is an elusive goal, but the use of multiple lenses can be very powerful in gaining an edge. Thus, to improve your performance in the art of spotting bubbles, focus on spotting auction house bubbles.
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Mansharamani is the author of Boombustology: Spotting Financial Bubbles Before They Burst. To order copies in bulk for your event, please visit BulkBooks.com.