Volatility in Equity  Markets

Hedge funds lost a total of $43 billion in September, and ongoing client redemptions are causing these funds' continuing liquidations of equity positions. As a result, the man who in 2006 first predicted the current worldwide economic recession, Nouriel Roubini, is now forecasting the near-term closure of equity markets for as long as a week in an effort to stem sharp losses. 

In a sign of the stock market's widening impact upon the real economy, consider the fact that over the past fifteen months thru October 7th, Pension funds lost $2 trillion in value, while the agency that guarantees that these funds will have the dollars they need, the Pension Benefit Guarantee Corp, thru August has lost $2.2 billion on its investments. 

The CBOE Volatility Index is currently at levels never before reached since its inception. And as any money manager will tell you, it's not the bad news that is most jarring to a stock's performance, but rather uncertainty, and prospects for near or intermediate term stock market performance remain anything but predictable. If, as some have predicted, the market as represented by the S&P 500 posts $50-$60 in earnings next year, then applying a recession-level multiple to that number would yield an S&P at 500-600, nowhere near today's level near 900. 

Also consider the fact that the Dow Jones Industrial Average, having lost 37% year-to-date, cannot have fully discounted the full effects on our consumer-driven society of almost daily downsizing announcements from corporate America. There is little reason to expect the stock market to quickly resume an upward trajectory when consumers, who have for many years provided the fuel to our economy, can no longer rely upon refinancings to fund their spending, and are in fact declaring bankruptcy at almost unprecedented rates. One million jobs have already been lost this year and economists' estimates are for another million to disappear going forward. Continuing the trend, yesterday's report of jobless claims came in at a higher than expected 15,000 last week . 

All of the above facts point to a need for investors to employ a risk-reducing, diversified investment strategy, incorporating alternative assets. Even absent the conditions present in the market today, making the deliberate decision to be fully invested in the stock market inherently implies acceptance of a degree of risk. In that case then, the decision should be made to diversify with the inclusion into the portfolio of assets which have no or little correlation with the market, in order to minimize risk and maximize return potential.

As a real and tangible versus a monetary asset, art's low correlation with the stock and bond markets makes it an excellent diversification vehicle -- enabling reduction in overall portfolio risk and enhancement of overall risk-adjusted return. The relative strength in art's performance over the past decade is, at least in part, attributable to the broadening collector base; sixty percent of Sotheby's clients over that time period are new to the auction house. 

Even more important, however, is the fact that many view art not as a discretionary luxury, but instead as the store of value that it has always been, especially during economically trying times. Art has often been one of the most stable, not to mention profitable, investments during uncertain economic times. In fact, when the stock market took a swoon in 1987 and again in 2001, outperformance by the art market was notable.

Two NYU economists, Jianping Mei and Michael Moses, developed the Mei Moses All Art Index. The index analyzes the repeat sales of over 12,000 works of art at auction since 1950 to generate precise return data. The pair reported in an article in Forbes that "during the armed conflicts of lengthy duration of last century, art indexes outperformed major stock indexes." When stock markets fell during World Wars I and II, art outperformed the S&P during most of those years, and by 1920 had risen to 125% of its 1913 value (versus 94% for the market). Further, while the S&P 500 increased 67% during the Korean War (1949-1954), art was up 108%, and during the Vietnam War (1966 to 1975) when the S&P 500 fell 27%, art rose 256%.

However, art's outperformance of the equity markets is not confined to times of war, but surpasses the more traditional investment vehicles as well when the markets are roiled by a troubled economy, exactly the situation we find ourselves in today. In an article in InvestmentU, Mei/Moses analysis of data from the 27 recessions since 1875 reveals that art does quite well in tough economic times. Investors want and need to invest their money but when confronted with volatility-producing uncertainty, the foundation of the bellwethers becomes rocky, and investors turn to art.

For example, in 2000, the U.S. economy was facing many of the same conditions as it does today: declining retail sales, reduced capital spending and tightening bank credit standards. The peak in the Dow Jones Industrial Average that occurred on March 10, 2000 was followed by a loss of almost $3 trillion in market value and an overall loss for the year above 10%. Results for art were much different however with the Mei/Moses Index gaining 16%. In addition to its outperformance, art has a low correlation with the stock and bond markets which makes it an excellent way to diversify a portfolio, and reduce overall risk. Far from being a luxury, it can be argued that art is an essential component of any portfolio.