Bloomberg on the "Lafite effect"

Aug. 24 (Bloomberg) -- Kevin Hassett

One of the strangest developments in financial markets this year is the “Lafite effect.” It offers a valuable lesson about investing.
This financial crisis has walloped just about everything. It has even pushed down prices for fine wine.

The Vintage Wine Fund, which invests “in fine wine with an objective of steady, high capital growth,” declined 33 percent in 2008. This is newsworthy. In a 2008 paper, economists Lee Sanning, Sherrill Shaffer and Jo Marie Sharratt at the University of Wyoming demonstrated that wine investments provide enormous positive returns over time, with almost no correlation to the market as a whole.

Their study provides a textbook example of the problem with risk analysis. Until that time, the correlation of wine with the overall stock market was essentially zero. A hedge fund that bet on that remaining true would have lost big, because this time everything moved together.

One set of wine investors survived unscathed: those who bought and held the fine French wine Chateau Lafite Rothschild.
According to data compiled by wine exchange Liv-ex, the average list price for a bottle of 1982 Lafite was $3,386 in July, the highest ever. That’s about $280 higher than it was last year, and more than $1,100 higher than in 2007. Not bad for a bottle that you could have purchased for about $20 back in the 1980s.
So strong is the 1982 Lafite that its value largely withstood a downgrade, to 97 from a perfect 100, by U.S. wine maven Robert Parker. If you consider how much wealth has been destroyed in the past year, you would think that such a markdown would have devastated prices. Think again.

Lafite Index
The run-up appears to have affected all things Lafite, not just the 1982 vintage. The effect is so striking that Liv-ex created a new index to track the prices of the Lafite vintages from 2000 to 2006. That index is now only 4.4 percent below its long-term high. Few investments have done better.
The question for an investor is this: Is the Lafite price spike yet another bubble, or are there sound fundamental reasons?
One sound argument that might explain the increase is that there is a special “Lafite effect” associated with Asia. As wealth has increased there, the demand for luxury commodities such as Lafite has skyrocketed. “Right now, it’s almost an insult in some places to serve something other than Lafite,” Liv-ex’s director, James Miles, told me last week.
With the Lafite supply limited, this high demand for the supreme trophy wine has pushed prices through the roof.

As Asia Goes
Since Asia will presumably continue to grow in wealth, one might expect that demand will skyrocket and that today’s prices will someday look cheap.
The Lafite price might just as well drop sharply, and the argument for a decline is probably more compelling.

For one thing, prices might be higher now because of a speculative bubble.
Also, Asian consumers might become more sophisticated and grow to appreciate other wines, which they now shun, that are close substitutes for Lafite. If they do that, today’s prices might be a high water mark for some time. The 2000 vintages of both Lafite and La Mission Haut Brion both received perfect scores of 100 from Parker, for example. Right now Lafite costs more than twice as much.
The decision on investing today in Lafite probably turns on this question of whether it will become more socially acceptable to serve fine wines other than Lafite in the wealthiest corners of Asia. Today’s high prices suggest there are enough people willing to bet that Asian demand for Lafite continues on its trajectory.

By Kevin Hassett, director of economic-policy studies at the American Enterprise Institute, is a Bloomberg News columnist. He was an adviser to Republican Senator John McCain of Arizona in the 2008 presidential election. The opinions expressed are his own.