Financial Markets and the Indian Rope Trick

by George Hatjoullis

Indian Rope TrickFinancial markets often seem to elevate themselves without any visible means of support through an odd process of double counting. This is in direct contradiction of the efficient market hypothesis (EMH) and, for once, even common sense. I first drew attention to this in a letter to the Financial Times published 28 January 1985 and reproduced above. The thrust of the letter was that the equity market had apparently rallied on the back of the publication of the longer leading indicator but the rise in the indicator was largely driven by the rally in stock markets. Stock indices are a material component of such indicators because they are forward-looking.

These days it is the ZEW Financial Market Survey that is the culprit. Once again I have already drawn attention to the incongruous market response to the ZEW Indicator of Economic Sentiment in a letter to the Financial Times ( The ZEW index measures the difference between the positive and negative responses of around 350 market participants. One might reasonably assume that, since these are market participants, their views are already collectively impounded in market prices. Why then does the market respond to publication of such information as if it is news?

One possibility is that the market is not informationally efficient. The inclusion of stock market indices to a composite index of leading indicators, the composition of which is known, somehow creates information that the market finds useful. Similarly, the publication of a survey of institutional investors and market analysts, all of whom are continuously involved in markets, creates new information that is pertinent to asset valuation.

In the case of the leading indicators it seems unlikely that anything new is created unless the manner of combination of components is valued and unknown. This is not the case. In the case of the ZEW, the collective sentiment of this sample of participants must be of value and not available elsewhere. This is conceivable but also improbable. There are many indicators of market sentiment and it is unlikely that the ZEW either leads or adds anything to these. A nice research paper if it has not already been attempted ( I have not done a literature search).

Another possibility is that we are being treated to an insight into how irrational exuberance and bubbles develop. Rising prices bring forth more buyers and reported optimism by professionals encourages retail investors (invariably late). Once trends begin they often overshoot and this sort of phenomenon might give a small insight into why. Whatever the reason it is always best to look carefully to which published data the market is reacting.