Plus ça change

Something for everyone who reads this blog, Bento, for the money-grubbing, “econoblog”-reading crowd, as well as the student of Spinoza. Get this: a book by a contemporary of Spinoza, a fellow Portuguese Jew no less, living in Amsterdam, writing about investing!

Published in 1688, Joseph de la Vega’s Confusion de Confusiones (here reprinted as a “B-side” to Extraordinary Popular Delusions) is a book in the now neglected dialogue format, between a know-it-all “shareholder”, who takes it upon himself to educate a naive “philosopher”, and a wily but uninitiated “merchant”, in the treacherous mysteries of the Amsterdam stockmarket of the time.

I mention it not just as an interesting curio, but also to make a serious point. Contra the otherwise reasonable and only-a-little-bit-wrong Richard Bookstaber, we are not living in a time of unprecedented innovation, sophistication and complexity in financial markets. We are living in a time of unprecedented market depth, breadth, and liquidity it is true, enabled by IT, globalisation, etc. This is not new, however; we have always been living in a time of unprecedented market depth, breadth, and liquidity. To say that we are more innovative and sophisticated in terms of the financial products we create — outside what is enabled by technology –than at anytime in the past seems to me to sell very short those who came before us, and who were able to devise working, complex financial products without the vast benefit of computers, but rather with nothing more than pen (quill?), paper, abaci, applied arithmetic and ink.

Indeed Taleb (hat tip to Felix) makes reference to de la Vega in his latest broadside against Black-Scholes-Merton, the “inventors” of the “formula” that “prices” options. His point is that high volumes of derivative products were traded and priced before the evil Gaussians got their hands on them, and that what we call the BSM model was in any case derived from someone else’s work. Options are and have always been priced by traders just like anything else, say Taleb and Haug: according to the laws of supply and demand, and you don’t need a clever formula for that. The options market in C17th Amsterdam was probably priced as “accurately” as our own. More so, perhaps, due to its pristine, pre Gaussian state.

I have my own theory about option pricing: option are priced by whatever the market makers think they can get away with, the dogs. I know this from bitter, recent experience, having probably made a few of the ones running the market in TomTom very rich indeed.

Certain features of the C17th Amsterdam stockmarkets struck me as interesting:

Firstly, these guys could only trade 2 stocks! The Dutch East India Company and its poorer sister the West India were the only listings on the exchange. The business of both was sending risky and expensive expeditions to far flung outposts to sell Dutch wares to locals, bringing back spices and exotic goods. Such revenue would be, as we would put it today, “lumpy”. East India stock was probably only the reserve of the rich, like that in Berkshire Hathaway today. The nominal value of a fully paid up shares was very high, over 17,000 Guilders in 1688. I have no idea how much this is in today’s money. 

The second astonishing thing is the sophistication of the market of the time. There were options or “opsies”, “ducaton” shares, and rampant short selling, and everyone seems to have been trading on margin. It is hard to learn much about opsies from de la Vega himself, but The market must have been reasonably liquid as the Shareholder urges the Philosopher, tempted but initially reluctant to dip his toe in the water, to restrict his trading only to opsies; at one point he suggests a straddle. Ducaton shares were paid up shares of East India broken up into more manageable chunks and priced by a man with a stick off the price of the main line of stock at month’s end. It was a popular retail product, it would seem, “engaged in by both sexes, old men, women and children”, the latter betting their pocket money: eventually, it seems, it came to a sticky end.

One curious feature was the Appeal to Frederick: de la Vega doesn’t go into it in the detail I would like, but apparently it was a measure designed to discourage short-selling, as unpopular then with financially ignorant Germanic politicians as it is today, the eponymous Frederick being the Stadholder (Dutch head of state) of the 1630s. Apparently, if you had just taken a bath on the long side and were able to prove your counterparty had sold you shares short, in other words without owning them at the time, you could “appeal to Frederick”, and renege, ie you didn’t have to pay at all (settlement was like T -25 days or the 3rd wednesday every month or something). He doesn’t say how you could prove you had been sold short, or what would happen to those who had made the appeal — presumably they would not be trusted as a counterparty next time, and may even have had to stop trading. I guess it must have acted as a “get out of jail free” card, a last resort, something useful to deploy if you ever really really really got your face ripped off. I am pleased it is an idea that died out; it would have surely had the opposite effect intended by encouraging the most egregious plunging. And we get upset about the Greenspan or Bernanke Put! 

One of Bookstaber’s theses is that as we run “tightly correlated” markets, we are prone to periodic blowups. Well, de la Vega’s market seems to have had blowups much nastier than anything I have experienced. He tells of the recent “unheard of collapse in the price of the shares, which spelled such a deplorable crash in so short a time”. The market was caught leaning the wrong (bullish) way when a rumour that a recently arrived treasure-ship was carrying less gold than last year. ” The blow could not have been so severe if the contremine (bears) had not speculated on a rise too”. An immediate -20% whoosh down followed, followed by a further drop as the crafty bears, now short, spread rumours of an imminent war, despite the fact that “as things turned out, the importations. . . yielded an exceedingly fine result”. While East India recovered quickly, being down 50% must have been a nasty shock, and it apparently wiped out a lot of the ducaton traders in particular.

Some truths of investing seem eternal; for instance, de la Vega recognises the huge advantage better information and analysis begets:

If the wise speculator is eager to correspond with India  in order to learn . . . whether many ships are sailing to the motherland, and whether they are richly laden, particularly with spices, it has been shown that, although there are difficulties, information about them all can be obtained.

However, he realises that no matter how well you know the form of the horses in the race, yours can still fall over and get the botts in the final furlong

Even if we assume that the news is good and correct (something which one can only tentatively establish from private letters), that the reports come at the right time, and that they announce the happy arrival of the ships, nevertheless an untoward event occurring subsequent to the acquisition of the news, but before the conclusion of the business may destroy this splendour and contentment. For ships can sink inside a harbour and hopes be thwarted.

How true. Happens to me all the time.

What also seems to remain unchanged is the propensity of participants to solidify into camps of optimists and pessimists with idées fixes. De la Vega has a fairly florid, allusive and obscurant style, which can grate, but he still manages to skewer both groups rather neatly. Like today, the bulls, or liefhebberen (“lovers” in Dutch):

are like the giraffe which is scared by nothing, or like the magician the Elector of Cologne,who in his mirror made the ladies appear much more beautiful than they were in reality. They love everything, they praise everything, they exaggerate everything. And as Bias deceived the ambassador of Alyattes during the siege of Priene by showing him hills of sand covered in wheat. . . that such a wealthy town would never surrender because of famine, so the bulls make the public believe that their tricks signify wealth and that the crops grow on graves. When attacked by serpents, they, like the Indians, regard them as both a delicate and a delicous meal.

Those oafs from Sandford Bernstein who plague me with their chirrupy voicemails spring to mind. And of course that Jimmy Glassman, of “Dow 36,000” fame. The bears, or “the contremine“, on the other hand — pay attention Buttonwood, this means you:

on the contrary are completely ruled by fear, trepidation, and nervousness. Rabbits become elephants, brawls in a tavern become rebellions, faint shadows appear to them as a sin of chaos. . . every dwarf will become a giant in the eyes of the bears.

De la Vega’s advice, which rings true to me, is to maintain a balance between cynicism and optimism:

If you wish to succeed in your enterprises, don’t drink continually from the well of the liefhebberen . . . but don’t drink always from the well of the contreminers either. . . In short, always speculate for a rise from natural inclination and on a fall only on occasion, because experience has shown that usually the bulls are victorious and the bears lose out

Finally, Confusion appeals to me because the author’s affection for the stockmarket shines through every sentence, even the ones where he is describing the nefarious shenanigans of speculators trying to fleece each other. No other job I know can offer the same variation, dynamism, intellectual stimulation, drama and excitement and sheer life, without being shot at, and this was clearly true in de la Vega’s day:

Among the plays which men perform in taking different parts in this magnificent world theatre, the greatest comedy is played at the exchange. There. . . the speculators excel in tricks, they do business and find excuses wherein hiding-places, concealment of facts, quarrels, provocations, mockery, idle talk, violent desires, collusion, artful deceptions, betrayals, cheatings, and even the tragic end are to be found.

Yeah, that’s still about right. What do you think, Bento?