As long-time readers know, we are big fans of the art world (see here, here and here as examples). By no means are we experts, but we do like to follow along at home in terms of visiting museums regularly, keeping up with who and what is "in" and advancing the avant-garde, and following the big art auction results in New York and London. It was the last area that recently caught our attention.

Last week at a Sotheby's auction in London, a painting by the anonymous English artist, vandal, political activist, film director and all-around prankster, Banksy, was auctioned off for $1.4 million. Immediately after the hammer came down to signal the auction ended, the craziest thing happened. A loud alarm emanating from the painting went off. Then the painting was slowly pulled through the bottom of the frame and shredded. The winner of the auction was left with the frame and a pile of vertically shredded strips of the painting. It was a brilliant prank by Banksy, which you can watch here.

Not so brilliant for the purchaser. Imagine that, you just paid $1.4 million for something and seconds later it is destroyed!

That feeling may be slightly like what the shredding U.S. equity market experienced last week. If you bought the SPDR S&P 500 exchange traded fund (an investment that tracks the action in the S&P 500 Index closely) on Friday October 5 at the close of trading, one week later you would be down a quick 4%. During the week the largest drawdown was just over 6% at its worst, which also represents an 8% drawdown from the recent market peak on September 20.

While we never ever know exactly why the market is going down or which direction it will head in the short term — it could be up, down or sideways. We simply do not know, and we do not have a crystal ball. One thing we know for certain is that when emotion and fear grow, capital markets usually become divorced from their underlying financial fundamentals.

There are several possible reasons why market volatility has spiked, including the following:

  1. Broadly speaking, we have said repeatedly the biggest risk to the business-cycle expansion is the Federal Reserve Bank and its continued campaign to increase interest rates. It appears the Fed is slated to raise interest rates in December and the latest view looks like market participants are betting the Fed will now raise three more times in 2019, which may now be too much, too fast or both. They will make a mistake at some point by tightening financial conditions and stalling out the business-cycle expansion. It is just a matter of when.
  2. Related to #1, interest rates across the curve have been rising and now offer better return competition to equity investments at the margin.
  3. The trade tariffs, while still ultimately small in terms of global corporate earnings, are starting to bite into global economic growth. There have been a few recent U.S. company earnings reports and future outlooks that have come in lower than expected due to rough ex-U.S. sales and anxiety about tariffs.
  4. Because we are now in the Q3 earnings reporting season, most publicly traded companies cannot buy back their stock until after they report earnings (due to regulatory blackout periods). Stock buybacks have acted as a huge demand driver for the market, and when that goes away the market can become unstable (same thing happened in February and April of this year).
  5. The midterm elections are getting closer and will be a source of anxiety for the market until it is all over. The market may be perturbed if the Republicans lose the Senate. The House turning Democrat now seems to be a foregone conclusion (but what do we know).
  6. Nikki Haley's departure as the U.S. Ambassador to the United Nations and the new rumors that James Mattis is leaving President Trump's cabinet fuel speculation the White House is in disarray. The market generally does not like political uncertainty when geopolitics continue to be a thing.

The market's response to these things is completely normal. Unfortunately, investors today have not experienced "normal" market volatility in a long time. Despite the shockingly long period of complacency (or the lack of very significant equity market sell-offs) since 2009, equity markets tend to correct (go down) by over 10% (peak to trough) in about 50% of any annual period. This has been the case since 1950 using the S&P 500 Index as a proxy. As a reminder, we have had a few corrections greater than 10% since 2009 and, low and behold, we survived! Similarly, we will survive those in the future as well.

Reacting emotionally to the downside volatility and not sticking to your financial plan in the short-term can be a long-term mistake. By selling, you realize a permanent loss of capital immediately and forgo the inevitable move higher. After all, eventually, over a long enough period, financial markets may move higher.

Similarly, believe it or not, the shredded Banksy painting may be worth more than the $1.4 million paid at auction now. Noah Charney, an arts columnist at Salon.com, frames it this way:

Presumably, the owner of this newly-shredded, newly-purchased painting took possession of the shredder frame and the dozens of long vertical slices that now represent the carcass of the work and will reassemble them into a unique work by one of the hottest artists in the world. Its resale value, prestige and cache are now tremendous and far greater than the painting alone. It seems probable that Sotheby’s was in on the gag, seeing as this was the last lot in the auction (it would have disturbed proceedings unpleasantly had it not been the last lot sold), and I’d say good for them for having a sense of humor, too often lacking in the art trade.

What appeared at first to be a tongue-in-cheek mocking prank, and then which also appeared to be a very clever publicity stunt, and then appeared to be a disaster for the buyer, is actually a clever way to immediately transform a painting that probably less than $25 to produce and a few hundred to frame, and which sold for $1.4 million, into a work now worth many times that thanks to a most singular destructive intervention.

Good news for the buyer! And the good news for market investors is that in the grand scheme of things, the short-term volatility we experience from time to time is nothing more than a blip. Given a long-term investment horizon, an investor may not remember these bouts of market turbulence ten, 20 or 30 years from now.

 

Contact Russell Moenich to learn more about this topic.
330.255.4330 | rmoenich@sequoia-financial.com

 

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