LEONARDO PISANO

People have been making judgements on what things are worth since one month's cave rental cost two woolly mammoth skins. But the focus of this book is stock markets. And while the Romans had developed a financial system of some sophistication by the 2nd century BC, it wasn't until the 17th century that publicly traded shares, as we recognise them today, were exposed to the question, ‘What are they really worth?' In 1602, the Dutch provided the first publicly traded stock, of the Verenigde Oost-Indische Compagnie, or VOC for short, which we know better as the Dutch East India Company. But it was several centuries earlier that the valuation tool they turned to was conceived.

Our valuation story really starts in 1202, when the book Liber Abaci first adorned bookshelves. Written long before the printing press was conceived, for the next 300 years it was considered Europe's pre-eminent text on the subject of business-related mathematics, and the concepts it introduced shaped the valuation formulae we still use today. Liber Abaci was the work of an Italian, Leonardo Pisano, better known as Fibonacci.

Pisano spent much of his early life outside his native country. His father worked as a public official in a Bugian customs house on the Barbary Coast of North Africa; the customs house had been established by the city of Pisa to facilitate trade in the region. Pisano's father saw the importance of a solid grounding in the principles of mathematics; hence from a young age Leonardo was provided with mathematical instruction. In particular he was instructed in the ‘Indian or Hindu Method', which used Arabic numerals.

It should be remembered that Europe had yet to adopt the Hindu number system, which is the system we use today. The Europe Pisano was born into was still using the abacus for performing calculations and the Roman number system to record the outcomes of these calculations. Pisano saw significant advantages in using the Hindu system, principally because it was less cumbersome than the Roman. Using the Hindu system it was possible to perform both the calculation and the recording. He explained that by combining the nine Indian figures (1, 2, 3, 4, 5, 6, 7, 8 and 9) with the sign 0, which the Arabs called zephyr, ‘any number whatsoever is written'.⁶⁴

Pisano wanted to see the widespread adoption of the Hindu system across Europe. When he left Bugia he travelled throughout the Mediterranean region, further developing his skills in trade and mathematics. In his own words, he learned from ‘whoever was learned in it, from nearby Egypt, Syria, Greece, Sicily and Provence, and their various methods, to which locations of business I traveled considerably afterwards for much study'.⁶⁵ His scholarly and intellectual interactions saw him rise to become one of the pre-eminent and most creative mathematicians of his time.

Pisano wrote Liber Abaci soon after returning to Italy in around 1200. It contains the first written record of a tool that investment analysts still use today — discounted cash flow. Concepts of debt and the calculation of interest had been considered, taught and written about long before Pisano. What made his work revolutionary was that it introduced a practical method for calculating the financial impact of varying the timing of cash flows. Today we would call it calculating a ‘present value'. The application of a discount rate to future cash flows is still central to the valuation of bonds and equities.

In chapter 12 of Liber Abaci Pisano poses a problem he calls ‘On a Soldier Receiving Three Hundred Bezants for His Fief'. He asks us to consider the financial impact of changing the timing of payments a soldier receives from the king. One scenario sees the soldier receive his annual salary of 300 bezants in four three-monthly payments, each of 75 bezants. Under a second scenario the soldier receives a single annual payment of 300 bezants at the end of the period. Pisano provides us with the discount rate — a monthly interest rate of 2 per cent — and then shows us how to calculate the difference between the two present values.

Pisano's time coincided with the development of innovative long-term government debt instruments in northern Italy. Both Venice and Genoa began to issue loans, giving birth to the now common practice of government financing through national debt. Whether the present value formula sparked the development of the government debt market or the government's desire to borrow initiated the development of the formula isn't clear. Whichever was the case, Pisano's formula provided the tool for calculating bond values down to the last bezant.

Pisano had provided the business world with a tool for distilling variously timed cash flows into a single value — today's value. He could not have guessed back in 1202 that this was the tool that analysts would utilise centuries later when attempting to pin values on stocks.

JEAN TRENCHANT

Three and a half centuries after Pisano, French mathematician Jean Trenchant further advanced the mathematics of discounting. His 1558 book L'Arithmétique contained a practical table to facilitate the number crunching. His book also described perpetuities — the mathematics of infinite series. This was another valuation tool to be picked up by future stock analysts, as, for the purpose of valuation, companies are commonly considered to have an infinite life.

I've no doubt Pisano and Trenchant were justly proud of their achievements, but there is a very large elephant in the room when you start using these tools to value stocks. The formulae are mathematically sound, but formulae require accurate inputs in order to provide accurate outputs. Future cash flows can be defined for bonds and annuities, and both are financial instruments to which Pisano's and Trenchant's formulae can be usefully applied. But the accuracy is lost when calculating stock values. Stock analysts are left to plug in guesses (sorry, ‘estimates'!) of what the future cash flows might be.

JOSEPH DE LA VEGA

The creation of the first publicly traded joint stock company, the Dutch East India Company (VOC), in 1602 launched a brand new sport: share trading. This meant an arena had to be built where traders could meet. Stock punters quickly discovered it wasn't much fun hanging around street corners during the cold Dutch winter. Work on the Amsterdam Exchange, the world's first purpose-built stock exchange, began in 1608 under the direction of architect and stonemason Hendrick de Keyser. Completed in 1611, it consisted of an open courtyard surrounded by a colonnaded archway to provide protection from the weather. And within this building a Sephardic Jew named Joseph de la Vega traded shares.

Fortunately for us, not only did de la Vega possess an intimate understanding of the Amsterdam Exchange, but he was also an accomplished writer. He left behind a priceless account of activity on the trading floor, Confusion de Confusiones, written in 1688. De la Vega's fascinating narrative reveals beliefs and experiences that were little different from those of modern-day analysts and investors. He judged that a driver of the stock price of the Dutch East India Company was whether ‘the business of the Company is moving forward, whether its operations in Japan, Persia, China are proceeding favourably, whether many ships are sailing to the motherland, and whether they are richly laden, particularly with spices'. He also saw that ‘opinion on the stock exchange itself' was important.⁶⁶

Let's pause for a while to reflect on these two statements by de la Vega, and compare them to the writings of Keynes, two and a half centuries later. In his 1936 classic The General Theory of Employment, Interest and Money, Keynes describes returns on stocks as being driven by two factors in combination. They are ‘enterprise', which relates to the prospects of the business, and ‘speculation', which relates to the psychology of the market. With this in mind, let's read de la Vega's comments again (remembering that he wrote them almost 250 years before The General Theory was published). Just like Keynes, de la Vega describes as important ‘the business of the company' (that is, enterprise) and the ‘opinion on the stock exchange itself' (that is, the psychology of the market).

De la Vega also told us he used calculations to analyse stocks. He didn't outline his methodology, but he did make the following comment, which indicates he probably used estimates of future dividends as an input:

The price of the shares is now 580, it seems to me that they will climb to a much higher price because of the good business of the Company, of the reputation of its goods, of the prospective dividends, and of the peace in Europe. Nevertheless I decide not to buy shares through fear that I might encounter a loss and might meet with embarrassment if my calculations should prove erroneous.⁶⁷

That de la Vega placed significant weight on the dividends when valuing VOC stock was more pertinent then than it is now. The company had a policy of paying out nearly all earnings as dividends, something that is now the exception rather than the rule. And since 99 per cent of company profits were paid out, it meant that for 50 years dividends were treated as a proxy for earnings.⁶⁸ De la Vega wasn't the only investor of his day who saw the close link between dividends and the share price; during the first 70 years of VOC's operations its share price and dividends moved in lockstep.

De la Vega's comment that he gave consideration to ‘the reputation of its goods' is interesting, as it evokes Buffett's contemporary advice to search out companies with an economic moat, among which might be those with a superior product or coveted brand or trademark. And de la Vega's fear that his ‘calculations should prove erroneous' might have been allayed if he'd applied Graham's ‘margin of safety' concept.^a Pity Ben wasn't around to guide him.

After discussing Pisano's discounted cash flow and de la Vega's dividend-based value calculations, it's interesting to reconsider the references to 20th-century financial economist John Burr Williams, who is sometimes hailed as the first to articulate the theory of discounted cash flow–based valuation, and is popularly credited with originating dividend-based valuation.

Wikipedia boldly states that Williams was one of the first to ‘view stock prices as determined by intrinsic value', ‘is recognised as a founder and developer of fundamental analysis … and was amongst the first to articulate the theory of discounted cash flow based valuation'.

Sorry, Wiki, but all three statements are wrong. Williams was born in 1900, centuries after those who should receive the credit for each of these ideas. It's unfortunate that such a popular source of information should dispense such myths, although, to be fair, Wikipedia is not alone in doing so.

SIR JOSIAH CHILD AND THE 17TH-CENTURY BUFFETT

The word ‘intrinsic' comes from the Latin word intrinsecus meaning inwardly or inward. It isn't clear when it was first applied to stock valuation.

The fifth edition of Ben Graham's classic tome Security Analysis has this to say on the matter: ‘We do not know when the term intrinsic value was first applied to investments, but it was mentioned in a pamphlet published in 1848, Stocks, and Stock-jobbing in Wall Street by William Armstrong.'

For the sanctity of Ben's memory it's fortunate these aren't actually his words (they were inserted in the fifth edition, which postdated his death), but whoever was responsible for them didn't dig deep enough. I don't know either when intrinsic value was first applied to investments, but I do know it was well before 1848. English aristocrat Sir Josiah Child, for example, referred to it in his 1681 book A Treatise Concerning the East-India Trade. He wrote:

When we tell gentlemen, or others, they may buy stock, and come into the Company when they please: they presently reply, they know that, but then they must also pay 280l. for 100l. And when we say the intrinsick value is worth so much; which is as true as 2 and 2 makes 4, yet it is not so soon demonstrated to their apprehensions, notwithstanding it is no hard task to make out.

Interesting words from the 1st Baronet of Wanstead. Seems in 1681 most investors were just as uncertain as they are today regarding a stock's real worth. Having confidence in your own valuation is difficult particularly when it's not within a bull's roar of what everyone else thinks it should be. But the fact that Sir Josiah was both the English East India Company's governor and its largest shareholder might help explain his confidence in determining the company's ‘intrinsick value'. A little bit of inside information always comes in handy in these matters.

Late in Sir Josiah's life a broadsheet published in London called the Athenian Mercury ran one of those ‘Dear Abby' columns where readers write in for advice on a variety of matters. (In fact its editor, John Dunton, is credited with initiating the Dear Abby concept.) The 7 April 1691 edition carried a very interesting letter from a reader. At the time London's financial markets were in the grip of a bull market. The reader had holdings in the English East India Company and the Royal African Company, both of which were trading at prices much higher than he'd bought them for. In explaining his dilemma he stated he could ‘now dispose of his interest at greater rates than he is assured they are really worth'. He even told the editor why someone might be stupid enough to buy his stock: ‘the ignorant buyer be wholly guided by other men's actions'.

Today we call this bull market phenomenon the ‘Greater Fool Theory'. Value is largely forgotten. Stocks are bought simply because they've been going up. And the expectation is they'll continue going up, so enabling the holder to pass them on later to another equally uninformed person at an even higher price. But this 17th-century reader seemed to break the mould. He appeared to be fairly savvy. He recognised share prices are subject to two powerful forces — value and emotion — and that an excessive amount of emotion was driving the prices he was observing. One might almost describe him as the ‘Great-great-grandfather of Behavioural Finance'.

The letter went on to present his dilemma. He wasn't looking for investment advice; rather, he was asking a moral question. Given the circumstances, would it be wrong to sell the overvalued stock to another man? Now really! Try asking that question today. You'd be heavily sedated within minutes of the doctor's arrival, and certified within hours. The attitude held by today's investors is that it's perfectly ethical to achieve the best possible sale price without regard to the faceless buyer on the other side of the trade.

The newspaper replied with a quote from the Bible: ‘Let no man go beyond, or defraud his Brother in any Matter, because the Lord is the Avenger of all such' (1 Thessalonians 4:6).

But is this 17th-century stock seller defrauding his brother? It assumes that his determination of value is the correct one. Consider also that ‘the ignorant buyer' is not alone in his apparent ignorance. The stock price is set by the combined views of many market participants, meaning the market is ignorant. Is this not the principle upon which every value investor hopes to operate today? So for this 17th-century value investor we need to say: ‘Bad luck, pal. You had the skills but you were born in the wrong century.' No investor today would consider this situation as a moral dilemma.

I wish I'd been able to talk to this 17th-century Warren Buffett, because this whole concept of what is a ‘just price' is one that philosophers had grappled with long before his day. To mention just three: Greek philosopher Aristotle had reflected on the doctrine of just price three centuries before the birth of Christ; 13th-century Italian philosopher Thomas Aquinas addressed it in his best-known work, Summa Theologica; and in the 17th century English philosopher John Locke wrote of price morality in a four-page essay entitled ‘Venditio'. Like Aristotle and Aquinas before him, Locke asks: what is the just price? Or, put another way, what is the price a moral person would charge another? Locke argued that the market price is the just price. So, according to Locke, our 17th-century Dear Abby writer shouldn't have been so worried.

Locke's justification was that if the shares were sold at a price below the market price they would likely be on-sold for profit by the next guy at the prevailing market price (today we refer to this as arbitrage). Under these circumstances the final owner of the shares would still have bought at the higher price. The first owner would simply have passed on his potential profit to an interim party.

THOMAS BASTON AND DANIEL DEFOE

The South Sea Bubble of 1720 preceded one of the most infamous stock market crashes in English history. And, as with every stock market bubble since, there were voices warning that it was all going to end in tears. Three of these voices belonged to Thomas Baston, Daniel Defoe (author of Robinson Crusoe) and Archibald Hutcheson. These three men didn't pin a date on the impending stock market crash. Rather, they acknowledged there is only so much air you can push into a balloon before it blows up in your face. The term ‘intrinsick value' was used by each of them when expressing their concerns.

Baston released his book Thoughts on Trade and a Publick Spirit in 1716. In it he expressed his concern regarding the number of new share issues for companies without sound business stories: ‘No sooner is any company erected … but immediately 'tis divided into shares and then traded for in Exchange Alley, before 'tis known whether the project has any intrinsick value in it.'

At the height of the South Sea Bubble Defoe wrote a book titled The Anatomy of Exchange-Alley: or, A System of Stock-Jobbing. He was critical of activities in the coffee houses and streets around Exchange Alley, where London's stock speculators congregated to trade. He starts his book with all guns blazing, describing the market as characterised by rampant manipulation by stock-jobbers for their own personal gain. Interestingly, he makes specific reference to Sir Josiah Child (who by then was 20 years in his grave) as ‘that original of Stock-Jobbing'. Defoe says: ‘If Sir Josiah had a Mind to buy, the first thing he did was to Commission his Brokers to look sower, shake their heads, suggest bad News from India …'

Defoe refers to ‘Intrinsick Value' twice in his book, and in the first reference he uses the term as we use it today:

That Six or Eight Men Shall Combine together, and by pretended Buying or Selling among themselves, raise or sink the Stock of the E. India Company, to what extravagant pitch of Price they will; so to wheedle others sometimes to Buy, sometimes to Sell, as their occasion require; and with so little regard to Intrinsick Value, or the circumstances of the Company …

The vitriol runs through his book from the first page to the last. Makes you wonder whether Defoe might himself have lost a pay packet or two in the market.

ARCHIBALD HUTCHESON

Archibald Hutcheson was a member of parliament for 14 years, from 1713 to 1727, which means the South Sea Bubble burst exactly halfway through his political career. When one reads of this 18th-century financial fiasco Hutcheson's name pops up everywhere. As the bubble grew, he became increasingly vocal regarding the heady prices South Sea stock was fetching in Exchange Alley. His concerns were based on his own valuation of the stock. Indeed, his capacity to undertake an independent valuation and then back it with powerful conviction has prompted a modern-day author, Richard Dale, to dub Hutcheson ‘the Father of Investment Analysis'. (Sincere apologies to Ben Graham from the Brits.)

Let's look at the tools Hutcheson had available for his valuation. Firstly, he used a method already being applied to valuing commercial property, the asset most commonly held by the moneyed gentry of his time. Steady rental streams meant property was relatively easy to value. As I've already mentioned, the income stream was capitalised by applying a multiple called ‘number of years purchase'. It was from this that our popular P/E multiple was derived, and the technique is still used to value commercial properties today. Secondly, he had Pisano's discounting formula. It had long been used to value the other principal asset of the day, government bonds.

While Hutcheson had access to both of these valuation tools (PE and discounted cash flow), he knew valuing stocks presented a unique set of challenges.

The share price of the South Sea Company had risen dramatically amid the euphoria of the South Sea Bubble, and Hutcheson set out to demonstrate that it was trading at ridiculously inflated prices. The company had two sources of revenue, one real and one potential. The real source was a steady stream of interest paid on loans it had granted the British government. The company received its charter in 1711 and the associated South Sea Act provided for the conversion of over £9 million of British government debt into equity. The then holders of British sovereign debt gave up their debt certificates and were issued South Sea Company share certificates in their place. This meant the British government owed the £9 million to the South Sea Company. The government made interest payments into the South Sea coffers, which were then passed on to shareholders in the form of dividends. Hutcheson had no trouble valuing this cash flow. He valued it just as he would a bond — using the discounted cash flow formula.

But it was pinning a value on the second arm of the company's business activity that proved to be difficult. The company's charter also granted it a trading monopoly over a large area of South America. The Act authorised ‘trading to the South Seas and other parts of America, and for the encouragement of fishing'.

At the time Hutcheson was making his ‘intrinsick value' calculations, the South Sea Company had been in existence for nine years. It was obvious to him that this second arm of business activity, the South Sea trade, hadn't amounted to much at all, and he doubted it ever would. It was a pretty fair call since South America was largely controlled by the Spanish, and England and Spain had been at war for years. Philip V of Spain wasn't about to let bygones be bygones and open up Spain's lucrative trade routes to its sparring partner, so Hutcheson excluded this part of the company's activities from his valuation.

Hutcheson was well known for his warnings regarding the dangerous state of affairs in Exchange Alley, including the prediction that share prices were changing hands at such inflated prices a financial crash was inevitable. On 11 June 1720 he entered the House of Commons armed with his most recent calculations on the value of South Sea stock. On taking the floor he declared to the House that, based on his calculations, South Sea shares had an ‘intrinsick value' of £200, against the current market price of £740. Hutcheson warned of what would happen when ‘the present reigning madness should happen to cease'.⁶⁹

Hutcheson's appeals for sanity were largely ignored and the share price of South Sea stock climbed even further. In July Hutcheson revised his calculations. Based on a recent third subscription of capital, he now valued it at around £300. The market price peaked that month at around £1000. The speculative frenzy had seen the share price increase eightfold since the start of the year.

If you were to speak charitably of the South Sea punters — those who were buying stock at nose-bleed prices — you might say they were just more optimistic about the company's trading opportunities in South America than Hutcheson, that they had the smell of Inca gold in their nostrils and believed the sky was the limit regarding future trading opportunities. But the reality is that few of them were giving any thought to these issues at all. All they saw was the rising share price, and the only trade they were thinking about was the one with the next mug punter who'd take the stock off their hands.

But economic reality always has a way of rearing its annoying head eventually, and by mid October South Sea's share price had collapsed by over 80 per cent from its July highs. Those who'd bought in at £1000 per share were crying poor. In the words of an anonymous pamphleteer of the day, their greed ensured they had become the ‘hindmost':

The additional rise of this stock above the true capital will be only imaginary; one added to one, by any rule of vulgar arithmetic, will never make three and a half, consequently, all the fictitious value must be a loss to some persons or other, first or last … the only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost.⁷⁰

The craziness of the prices at which South Sea stock was trading is brought home when you consider that at its peak the total market capitalisation of the company was £400 million. That represented twice the value of all the land in England. As the events of 1720 were unfolding the Duchess of Marlborough wrote:

Every mortal that has common sense or that knows anything of figures sees that 'tis not possible by all the arts and tricks upon earth to carry 400 000 000 of paper credit with 15 000 000 of specie. This makes me think that this project must burst in a while and fall to nothing.

Hutcheson wasn't drawn into the speculative madness as others were. Instead he behaved more like a battle-hardened analyst of the modern era. What he did was:

• perform his calculations without being influenced by the market price
• make a realistic assessment of where the business was heading
• apply a discount rate to derive a current value for the whole company
• divide this by the number of shares to establish an intrinsic value
• calculate the number of shares by applying a dilution factor for the potential exercise of outstanding options
• and (most importantly, and to borrow the words of Warren Buffett) prevent emotions from corroding his intellectual framework.⁷¹

So I ask: what's so modern about security analysis? I still hear people say it's an invention of the 20th century.

If you read Charles Mackay's classic book Extraordinary Popular Delusions and the Madness of Crowds, you might believe everyone in 1720 England had gone stark raving mad. But many were keeping their heads, and Hutcheson's calculations had an influence. Adam Anderson, the first historian of the South Sea Bubble, says the ‘fair and candid calculations' of ‘that ingenious gentleman Archibald Hutcheson' were having an influence in Exchange Alley and ‘some began to have their eyes opened by [his] judicious calculations'.⁷² Anderson would have known — he was working for the South Sea Company at the time.

It's important to stress, though, that Hutcheson wasn't a maverick defying the common belief of his time. Valuation metrics, familiar to us today, were regularly used in the 18th century. Another example is the use of dividend yield. Consider again these words, written nearly three hundred years ago by the author of ‘Remarks on the Celebrated Calculations', which I presented in the previous chapter:

The main principle, on which the whole science of stock-jobbing is built, viz. That the benefit of a dividend (considered as a motive to the buying or keeping of a stock) is always to be estimated according to the rate it bears to the price of the stock, because the purchaser is supposed to compare that rate with the profits he might make of money, if otherwise employed.⁷³

A near-perfect explanation of why stock prices go up when interest rates go down.

I can't leave this discussion of Hutcheson without referring back to a point made in chapter 10. I was referring to an article written by a technical analyst who denied that determinations of underlying value serve any useful purpose. Instead he proposed that there was great benefit in the use of charts because ‘the price chart summarizes the opinions and emotions of all market participants'. But after reading the story of the South Sea Bubble, can we really believe that Hutcheson would have been better informed had he based his judgement on ‘the opinions and emotions of all market participants', the majority of whom were chasing the price of South Sea shares skyward with no consideration of value?

THOMAS MORTIMER

Born in 1730, Englishman Thomas Mortimer was, by the age of 20, writing on the subjects of economics, business and politics. In 1761 his popular investment book Every Man His Own Broker hit the bookshops. It remained in print for 46 years, running to its fourteenth and final edition in 1807. In Mortimer's day stockbrokers didn't have a monopoly on the buying and selling of shares. Any investor could wander down to where stocks were being traded, rub shoulders with the brokers and trade on their own account. Mortimer's book, as the title implies, was written as a self-help guide for those who wanted to get down to Exchange Alley and get amongst it.

The advice dispensed by Mortimer was, in part, a product of his own bitter experiences dealing with the professionals down at the exchange. In 1756 he made what proved to be a very poor investment. In order to save on brokerage he entered Jonathan's Coffee House in London and purchased scrip on his own account. As Mortimer describes it, he lost a ‘genteel fortune'. His hostility towards stock-jobbers and their manipulative activities comes through in his writings.

In Everyman His Own Broker Mortimer offers his own views on stock valuation:

Every original share of a trading company's stock must greatly increase in value, in proportion to the advantages arising from the commerce they are engaged in; and such is the nature of trade in general, that it either considerably increases, or falls into decline; and nothing can be greater proof of a company's trade being in a flourishing condition, than when their credit is remarkably good, and the original shares in their stock will sell at a considerable premium. This, for instance, has always been, and still is the case of EAST INDIA STOCK in particular, not to instance another. The present price of a share of £100 in the company's stock is £134. The reason of this advance on what cost the original proprietor only £100 is, that the company, by the profits they have made in trade, are enabled to pay £6 per annum interest or dividend for £100 share. But then it is uncertain how long they may continue to make so large an annual dividend, especially in time of war; for several circumstances may occur (though it is not likely they should) that may molest their trade in their settlements, and diminish their profits…⁷⁴

Here Mortimer links the rationally determined share price to the sustainability of earnings and the size of the resultant dividends. He also highlights the importance of the company's credit (cash flow and gearing). Many of today's analysts would view these concepts as their modern-day intellectual property. Mortimer's words demonstrate how wrong that view is.

BEFORE CROSSING THE ATLANTIC

Before we leave Europe and cross to the United States, I want to recap the level of sophistication of both the financial analysis and financial securities already in use by the end of the 18th century. Let's use 1790 as our ‘line in the sand'. This was the year the US opened its first exchange, the Philadelphia Stock Exchange. Before the US markets opened for business, the foundations underpinning modern-day financial markets were already well established in Europe. Not only had publicly traded stocks been around for nearly two centuries, but by 1790:

• options on shares had been available for a similarly long period. From the very beginning Europeans had used options to take leveraged speculative positions, for engineering different investment risk profiles and for hedging physical positions — all uses to which they are put today.
• contracts for difference (CFDs) had long been in use. Derivatives with similar properties (called ducaton shares) were being used by the Dutch in the 17th century. In England Sir John Barnard's Act of 1734 specifically banned them or, as the legislation stated, prohibited ‘the evil practice of making up differences for stocks'. Here, three centuries ago, the English had identified and legislated against the high risks associated with the use of CFDs and the financial grief their trade was causing. Today they've been reintroduced as some sort of innovative marvel.
• there had long been an appreciation of what drove financial markets, in terms of both fundamentals and human psychology. Our current understanding has advanced little.
• the principles of valuation underpinning modern financial analysis — namely the application of multiples to earnings, discounting prospective dividends, and an appreciation of buying companies with solid balance sheets, good management and favourable business prospects — were well understood and regularly described in the early financial literature.

Now let's move our story to the United States, which for more than a century has been home to many of the largest and most powerful financial institutions in the world.