Abu Dhabi Stock Market Efficiency Case Study

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A number of economists suggest that markets are efficient, but this efficiency is merely assumed. In this regard, Batten points out that, "There is no actual proof. It is virtually impossible to test for market efficiency since the 'correct' prices cannot be observed. To get over this hurdle, most tests examine the ability of information-based trading strategies to make above-normal returns. But the results of such tests do not really prove whether markets are efficient. Therein lies the basic dilemma" (p. 210).

In his book, Stock Market Cycles: A Practical Explanation, Bolten (2000) reports that assuming that an economy begins in a trough (a period this author refers to a the first stage of the economic cycle), expectations are for positive economic growth and higher future earnings, which has a positive impact on stock prices. In this regard, Bolten points out that, "Interest rates are typically low at this period in the business cycle, which will positively affect stock prices due to a decrease in firms' cost of capital. Low interest rates also induce investors to transfer wealth from low-yielding bonds into stocks, which pushes up stock prices. The combined effect of these factors causes stock prices to rise relatively quickly at this stage, even though the economy may show only marginal signs of improvement" (p. 121).

During the second phase of the economic cycle, the nation's economy continues to grow and the demand for capital increases, a process that leads to inflationary pressure and interest rates begin to rise gradually (Bolten, 2000). The author adds that, "Expectations of future earnings increase due to the strengthening economy, however. At this stage of the cycle the positive impact of higher earnings expectations dominates the negative impact of higher interest rates. The overall effect on the stock market is positive and prices rise, although not as fast as in the first stage of the economic recovery" (Bolten, 2000, p. 121). The third economic cycle stage is characterized by continued economic expansion: "The supply of loanable funds cannot keep pace with the increased demand for capital, which causes the rise in interest rates to accelerate. As inflationary concerns worsen the Federal Reserve is likely to tighten monetary policy, which puts more upward pressure on interest rates. Furthermore, the rate of earnings growth begins to slow down due to diminishing marginal productivity" (Bolten, 2000, p. 121). These factors result in a decrease in the rate of economic expansion; stock prices increase slowly and eventually peak, even though the economy has not yet reached its peak (Bolten, 2000).

While the economy slows, interest rates may not immediately decrease. Inflationary pressures and the increased costs of financing unanticipated inventory accumulations and lagged accounts receivable collection will cause interest rates to continue rising. The combined effect of investors transferring wealth from stocks to bonds and the slow growth in corporate earnings has a negative effect on stock prices (Bolten, 2000).

During the fourth stage of the economic cycle, worsening economic expectations dim future earnings prospects, which has a negative effect on stock prices. The decreased demand for credit causes interest rates to begin falling. Stock prices will continue to decline until interest rates fall substantially, however. The downtrend in interest rates and improvement in earnings expectations eventually cause a rebound in stock prices (Bolten, 2000). These processes are illustrated in Figure ____ below.

Figure ____. Economic Factors and the Stock Market Cycle.

Source: Bolten, 2000, p. 122.

As noted above, Fama (1970) coined the term "weak-form market efficiency" and suggested three levels of efficiency; the semistrong form of market efficiency implies that markets adjust rapidly and in an unbiased manner to public information. Under the strong form of market efficiency, both public and private information are quickly impounded in the security price. Strong-form market efficiency implies semistrong-form market efficiency, and semistrong-form market efficiency in turn implies weak-form market efficiency (Batten, 2000, p. 282). The growing body of research into weak-form market efficiency that began with Bachelier concluded that stock prices follow a random walk. The random walk hypothesis means that at a given point in time, the size and direction of the next price change is random with respect to the knowledge available at that point in time. This implies that charting and all other forms of technical analysis practiced by various investors, amateur and professional alike, are doomed to fail. Market efficiency can also take a semistrong form or a strong form (Batten, 2000).

Market efficiency also seems to have its roots in the idea of intrinsic value. Although the value of most goods is acknowledged to be a function of consumer beliefs, preferences, and endowments, securities have often been treated as having a value independent of these consumer characteristics. Their value is based on the characteristics of the firm behind the security. This is a supply-side approach. The price of any security, however, depends not only on the characteristics of the firm or commodity involved but also on the demand for the security. In other words, it depends on the characteristics of the investor. To date, the most commonly used model to relate investors' current price expectations with future price distributions is the rational expectations equilibrium model (Batten, 2000). A fully revealing, rational expectations equilibrium occurs when prices reveal all the information held by individual investors (i.e., when price expectations are realized in a future period). "But whose expectations? If investors possess homogeneous beliefs, the choice of whose expectations to use is greatly simplified. In a perfect and competitive economy composed of rational individuals with homogeneous beliefs about future prices, by any meaningful definition present security prices must fully reflect all available information about future prices" (Batten, 2000, p. 211).

Economic Performance in United Arab Emirates in General and Abu Dhabi in Particular.

According to U.S. government analysts, the UAE has an open economy with a high per capita income and a sizable annual trade surplus. In spite of largely successful efforts at economic diversification, about 30% of the UAE's GDP remains directly based on oil and gas output, and the economic performance of the state is inextricably linked to the prices of those commodities. Since the discovery of oil in the UAE more than 30 years ago, the UAE has undergone a profound transformation from an impoverished region of small desert principalities to a modern state with a high standard of living; furthermore, the UAE government has increased spending on job creation and infrastructure expansion and is opening up its utilities to greater private sector involvement (UAE, 2007). In April 2004, the UAE signed a Trade and Investment Framework Agreement (TIFA) with Washington and in November 2004 agreed to undertake negotiations toward a Free Trade Agreement (FTA) with the U.S. Higher oil revenue, strong liquidity, and cheap credit in 2005-06 led to a surge in asset prices (shares and real estate) and consumer inflation. Rising prices are increasing the operating costs for businesses in the UAE and degrading the UAE's allure to foreign investors. Dependence on a large expatriate workforce and oil are significant long-term challenges to the UAE's economy (UAE, 2007).

The UAE enjoys the distinction of being the most stable country in the Middle East from both the perspective of internal security and politics, while the macroeconomic base of the federation is firmly based on the state's enormous hydrocarbon wealth; however, more than 90% of these resources are located in the emirate of Abu Dhabi (Strong fundamentals support Abu Dhabi property, 2006). Indeed, the capital city of the UAE is widely regarded as a geological marvel, and sits on some 10 per cent of the world's oil reserves and a considerable quantity of gas (Strong fundamentals support Abu Dhabi property, 2006). Moreover, extraction costs for the valuable resources remain among the lowest in the world. In addition, the UAE has not suffered from the instability of many of its neighbors and has quietly gone about developing its natural resources without violent lurches in policy and in partnership, rather than conflict with the major international oil companies (Strong fundamentals support Abu Dhabi property, 2006). Some key economic metrics for UAE are shown in Table ____ below.

Table ____.

Key Economic Metrics for UAE.


Current Est.

Global Rank

Economic freedom

25th of 156]

GDP > Nominal

51st of 184]

GDP > Nominal (per capita)

27,686.31 per capita

21st of 184]

Gross National Income

44th of 172]

Gross National Income (per capita)

19,198.30 per person

22nd of 172]

Human Development Index

41st of 178]

Income category

High income: nonOECD

Tourist arrivals

43rd of 152]

Trade with U.S. > U.S. exports of textile, sewing machines

24th of 183]

Source: United Arab Emirates, NationMaster, 2007.

Notwithstanding the above, the political system in the UAE remains plagued by some actual and potential problems, including the following:

The economy is extraordinarily dependent on foreigners, who make up at least 80% of the resident population, the…

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