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Somewhere in the mists of time, the three “Rs” of education were famously, and somewhat oxymoronically, defined as reading, ‘riting and ‘rithmetic.

Students were drilled in these three basic skills, which were seen as essential, and there wasn't much opportunity for diversification.

Today we live in different times with widely varied curricula and expectations.

However, there is something to be said for a good grounding in what we might better think of as fundamental concepts or first principles. Because an ability to read, write and calculate can take you a long way, particularly if you can pick up the skills of rational and critical thinking on your travels.

The utility of first principles doesn’t only apply to education. To my mind it's also very relevant to the markets and how we approach them.

Great discourse

One of the many great things about Macrodesiac as a forum is the discourse across its many channels.

Thought-provoking conversations can be had from 6 in the morning to well after my bedtime. In fact, I wonder if some participants get any sleep at all.

On Friday morning there was an exchange of views about the performance of the Euro Stoxx 50 index, which is up by almost +11% ytd. The discussion centred around whether those gains were justified by the macro background in Europe. Things are still looking shaky, despite a mild winter (thus far), falling natural gas prices and reduced energy consumption.

Investment banks have had conflicting thoughts about Europe's prospects in the last week. Goldman Sachs no longer anticipate a recession on the continent and Deutsche Bank has upgraded its German GDP forecast to zero, effectively ruling out a winter recession for Europe's powerhouse economy.

However, earlier in the week, and again this morning, JP Morgan has suggested that it’s time to take profits in European equities.

This is a sentiment that I disagree with.

Not because I have any strong insight into, nor insider knowledge of Europe’s economy over the balance of 2023, but rather because the price action has been saying exactly the opposite.

The older I get the more simplified or “fundamental” my take on the markets becomes.

When I say fundamental in this context, I don't mean the nitty gritty of balance sheets and ratios. Instead, I mean the first principles of the market and trading, which to use the vernacular from my opening comments could be classified as the three “Rs” of trading.

Namely, Rotation, Reversion and Repetition.  

We will come back to these concepts in a moment.

Why has the Euro Stoxx performed so strongly?

My take on the Euro Stoxx 50 can be summed up from the candle chart above.

The breakout/uptrend in the index started back on October 17th when European equities were at a valuation low point relative to their US peers.

The ratio chart below (Euro Stoxx 50/S&P 500) provides us with a flavour of that disparity.

The uptrend in Euro Stoxx 50 continued until December 15, at which point a brief downtrend ensued. The subsequent consolidation around 3800 became a new uptrend on January 2nd.

At the time of writing that uptrend remains in place and while it does there is no reason to bet against it.

The three “Rs”

Now back to those three “R's”... The upside in the Euro Stoxx 50 came about and continued because of the existence of these first principles:

Rotation: Money in the markets rotates from asset class to asset class, index to index, sector to sector and stock to stock. Long-term real money investors, hedge funds, and asset allocators help manage the money and move capital to where they think the opportunities lie.

Reversion: Reversion to the mean or the expectation of it, is a big driver of asset allocation decisions. The perceived wisdom here is that outliers, be they under or over-performers, will ultimately fall back in line or play catch-up with their peer group. This is exactly what has happened in the Eurostoxx 50.

Repetition: These concepts may not be fashionable/sexy so they don't get discussed on social media in the way that a meme stonk or cryptocurrency does. However, the difference is that these concepts are enduring. It's often said that the market may not have a memory (I think it does) but it does rhyme - which means that although events don't repeat exactly as before, similar events will reoccur in future.

Quants know these traits exist

You don't have to take my word for it either. These trends and principles are well-known and documented. There are even mathematical and statistical tools aimed at highlighting and quantifying them.

For example, the Hurst Exponent, which can be used to measure/estimate the long-term memory of time series data.

Originally developed to construct dams and ensure they were up to the task, quant funds and traders use the exponent to test market data looking for mean reversion and repetitive & persistent trends.

As with correlations in financial markets “market memory” has been shown to vary based on time scales and the number of inputs that are measured. The rule of thumb seems to be that short-term data, daily and intraday, is just white noise but that patterns do show up in longer-term data.

The Hurst exponent overlaps with the study of distributions and the mathematics of fractals  and if you would like to know about it and its application in financial markets then this article is a good jumping-off point.

“Put simply, the Hurst exponent is used as a measure of the long-term memory of a time series…While investigating the fractal nature of financial markets [and] specifically, the tendency of a time series to regress strongly to its mean or to cluster in a direction… mathematician Benoit Mandelbrot introduced to fractal geometry…the term generalized Hurst Exponent.”