Is the ZEW indicator reliable? Effectiveness analysis

16.05.2023 13:18|Analyst Team, Conotoxia Ltd.

The ZEW Institute (Zentrum für Europäische Wirtschaftsforschung) has been conducting monthly interviews with up to 300 experts from banks, insurance companies and financial departments of selected companies since 1991. The purpose of these interviews is to obtain assessments and forecasts of important international financial market data. Participants are asked about their expectations for the next six months regarding the economy and financial markets. Based on the results of the ZEW Financial Market Survey, an indicator called the ZEW Indicator of Economic Sentiment is created and published. Let's find out how much we could trust the experts' predictions?

Latest reading worse than forecast

The ZEW Index is mainly applied to the German economy and is used to measure economic sentiment and the expectations of experts and investors. Survey participants are asked about their forecasts for future economic growth, inflation, interest rates and the health of financial markets. The ZEW Index is an early indicator that can be used to assess market sentiment and expectations, as well as to predict the direction of the economy. Positive ZEW values mean that experts anticipate an improvement in markets over the next six months, while a negative value means that most experts predict a deterioration.

The latest reading of the ZEW Index recorded a significant drop in May 2023. The score of minus 10.7 points (against an expected minus 5.3 points) represents a reduction of 14.8 points compared to the previous month. This is the first time since December 2022 that the ZEW index has been in the area of projected deterioration. The assessment of the economic situation in Germany also shows a decline, where the corresponding indicator lost 2.3 points and currently stands at minus 34.8 points.

"The financial market experts anticipate a worsening of the already unfavourable economic situation in the next six months. As a result, the German economy could slip into a recession, albeit a mild one. The sentiment indicator decline is partly due to expectations of further interest rate hikes by the ECB. Additionally, the potential default by the United States in the coming weeks adds uncertainty to global economic prospects" comments Professor Achim Wambach, President of the ZEW Institute, on the survey results.

Source: https://www.zew.de/en/publications/zew-expertises-research-reports/research-reports/business-cycle/zew-financial-market-survey

Source: Conotoxia MT5, DE40, Daily

What is the predictive effectiveness of specialists?

Examining the monthly index readings, let us answer the question of how successful the professionals have been in predicting the next 6 months. It turns out that the correlation of the ZEW index reading against changes in the quotations for the next 6 months of the S&P 500 and DAX index is 0.29 and 0.15 respectively. This means that the correlation is negligible. Interestingly, it appears to be more correlated with the US S&P 500 index. However, it still could not be that a positive reading of the ZEW index would mean growth on the indices.

Source: Own analysis

In the graph above, comparing the ZEW index (right axis) with the actual changes in stock market indices after 6 months (left axis), it can be seen that the index sometimes accurately predicts the outcome and sometimes not. One may therefore wonder whether the change in the index readings from month to month is of greater importance. However, an analysis of the correlation between these indicators showed only a weak correlation of only 0.12 for the S&P 500 and 0.07 for the DAX. See chart below.

Source: Own analysis

In what period do the ZEW's predictions come true most?

The highest performance for the results of the ZEW index versus the forecasts of the DAX index was recorded for the day after the publication of the data. The correlation was 0.23 for the S&P 500 and 0.19 for the DAX index. Let's try to represent this data in a graph, where we give the actual change in the indices on one axis and the readings according to the ZEW index on the other. We will see a very large scattering of the data (see figure below). It is hard to draw any correlation from it, which shows how weak the ZEW index reading was in this aspect.

Source: Own analysis

Again, it would seem that the change in the ZEW index (in points), would better reflect trends and changes in the markets in the short term. However, it turns out that if we juxtapose real index changes with the change in the ZEW index, the highest correlation occurs for index price changes two days after the publication of the reading and decreases to 0.15 for both indexes.

Source: Own analysis

ZEW index performance dependent on changes in indices?

The highest correlation between the index score and the market occurs with a three-month lag. The correlation for such a comparison is 0.6 for the S&P 500 and 0.63 for the DAX respectively. This would mean that after a three-month rise in the markets, we could expect positive readings of the ZEW indicator. It follows that we will sooner read what the ZEW index score will be from the change in the indices over the past three months than we will know the actual expectations for the indices. We can observe this in the diagram below, whose readings have noticeably started to show a relationship forming.

Source: Own analysis

 

Grzegorz Dróżdż, CAI, Market Analyst of Conotoxia Ltd. (Conotoxia investment service)

Materials, analysis and opinions contained, referenced or provided herein are intended solely for informational and educational purposes. Personal opinion of the author does not represent and should not be constructed as a statement or an investment advice made by Conotoxia Ltd. All indiscriminate reliance on illustrative or informational materials may lead to losses. Past performance is not a reliable indicator of future results.

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76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. 76.23% of retail investor accounts lose money when trading CFDs with this provider. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
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