Abu Dhabi Stock Market: Efficiency and Transmission Mechanisms

Introduction and Background

In the 19th century, the Trucial States of the Persian Gulf coast granted the United Kingdom control of their defense and foreign affairs. In 1971, six of these states — Abu Zaby, Ajman, Al Fujayrah, Ash Shariqah, Dubayy, and Umm al Qaywayn — merged to form the United Arab Emirates (UAE), and they were joined a year later by Ra's al Khaymah (United Arab Emirates, 2007). Today, the UAE enjoys a per capita GDP on par with those of leading West European nations, and the state's generosity with oil revenues and its moderate foreign policy stance have allowed it to play an increasingly vital role in regional affairs (United Arab Emirates, 2007).

This point is reinforced by Al-Alkim, Al-Sayegh, Al-Shamsi, and their colleagues (1999), who report that "by investing and reinvesting the nation's wealth in productive enterprises, the UAE has been transformed into a nation with one of the highest per capita incomes in the world and, arguably, the best quality of life in the Middle East. The gross domestic product is now $50 billion" (p. 2). Throughout the UAE, health care is free of charge and the infant mortality rate is among the lowest in the world; likewise, education is free and the UAE has one of the highest literacy rates in the developing world (Al-Alkim et al., 1999). During the period from 1971 to the late 1990s, the UAE's population increased more than 15-fold and life expectancy rose from 60 years to 75 years (Al-Alkim et al., 1999). Given this environment, understanding how the Abu Dhabi securities exchange contributes to the nation's economic development has assumed new importance and relevance.

Like other Gulf Arab states, the United Arab Emirates has made enormous efforts in recent years to reduce reliance on the dominant public sector and to provide private investors a larger role in the economy (Abdou, Al Zarooni & Lewis, 2006). To this end, the government of Abu Dhabi has implemented a number of initiatives designed to make privatization part of its policy. Privatization of public service entities has proven successful in Abu Dhabi, particularly following the privatization of the power and electricity sectors (Abdou et al., 2006).

According to Eugene Fama's (1970) seminal study of market efficiency, the primary hypothesis following from the quick and accurate reaction of stock market prices to new information is that stale information is of no value in actually making money. To evaluate this hypothesis empirically, researchers need to define both "stale information" and "making money." The first definition can be established in a relatively straightforward manner; however, defining "making money" remains highly controversial (Shleifer, 2000).

In this regard, Shleifer (2000) emphasizes that "the reason is that 'making money' in finance means making a superior return after an adjustment for risk. Showing that a particular strategy based on exploiting stale information on average earns a positive cash flow over some period of time is not, therefore, by itself evidence of market inefficiency" (p. 6). In order to earn a profit, an investor may have to bear risk, and the profit may simply be fair market compensation for risk-bearing. This demands a model of the fair relationship between risk and return. One widely accepted model for this purpose is the Capital Asset Pricing Model, though it is not the only available alternative. As Shleifer notes, "The dependence of most tests of market efficiency on a model of risk and expected return is Fama's (1970) deepest insight, which has pervaded the debates in empirical finance ever since. Whenever researchers have found a money-making opportunity resulting from trading on stale information, critics have been quick to suggest a model of risk — convincing or otherwise — that would reduce these profits to fair compensation for risk-taking" (2000, p. 6).

By contrast, the definition of stale information is much less controversial. Fama differentiates between three types of stale information, which provide the basis for three forms of the efficient markets hypothesis. The so-called weak form of efficiency holds that the relevant stale information is represented by past prices and returns (Shleifer, 2000). The weak form of the efficient markets hypothesis maintains that it is impossible to earn superior risk-adjusted profits based on the knowledge of past prices and returns. As Shleifer explains, "Under the assumption of risk neutrality, this version of the EMH reduces to the random walk hypothesis, the statement that stock returns are entirely unpredictable based on past returns" (2000, p. 6). The semi-strong form of the EMH states that investors cannot earn superior risk-adjusted returns using any publicly available information. In other words, as soon as information becomes public it is immediately incorporated into prices, making it impossible to profit by using it to predict returns. A semi-strong form efficient market is therefore also weak form efficient, since past prices and returns constitute a subset of the publicly available information about a security (Shleifer, 2000).

Stock Markets and Economic Growth

The purpose of this study was to determine whether the Abu Dhabi stock market is efficient, what type of analysis mechanism is best suited for identifying investment opportunities, and what the implications are for investors and the state. This study used a six-chapter format. Chapter One introduces the topic, states the problem, and provides the purpose and overview. Chapter Two provides background, a discussion of stock market performance and economic growth, and an analysis of economic performance in the UAE in general and Abu Dhabi in particular. Chapter Three describes the research methodology, and Chapter Four provides data analysis to determine the historic efficiency of the Abu Dhabi stock market. Chapter Five presents results and findings, and Chapter Six provides conclusions.

From a pragmatic perspective, efficient markets appear to help stimulate economic growth, though a number of assumptions are involved. In the case of stock exchanges, for example, common stocks are traded on well-organized exchanges like the New York Stock Exchange, or in dealer markets called over-the-counter markets, in a process that facilitates the rapid execution of buy and sell orders (Batten, 2000). According to Batten, "The price response to any change in demand caused by new information can be almost instantaneous. Such stock markets are also competitive due to the large number of participating individuals, institutions, corporations, and others. Competitive forces also tend to cause prices to reflect available information quickly" (2000, p. 210). Markets capable of quickly and accurately reflecting available information are considered efficient; those that adjust more rapidly and accurately are considered even more efficient (Batten, 2000). Many economists assume that markets are efficient, but this efficiency is merely assumed — there is no actual proof. Batten points out that "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 Stock Market Cycles: A Practical Explanation, Bolten (2000) reports that assuming an economy begins in a trough — 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. Bolten notes 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, leading to inflationary pressure as interest rates begin to rise gradually (Bolten, 2000). "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 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 own 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 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, further depressing 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).

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

Market efficiency also appears to have 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 — one 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 but also on investor demand. 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. "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 and the Abu Dhabi Securities Market

According to U.S. government analysts, the UAE has an open economy with a high per capita income and a sizable annual trade surplus. Despite 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 country has undergone a profound transformation from an impoverished region of small desert principalities to a modern state with a high standard of living. The UAE government has increased spending on job creation and infrastructure expansion and is opening 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 United States. 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, which increased the operating costs for businesses and degraded the UAE's attractiveness to foreign investors. Dependence on a large expatriate workforce and on oil remain 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 built on its enormous hydrocarbon wealth. More than 90% of these resources are located in the emirate of Abu Dhabi (Strong fundamentals support Abu Dhabi property, 2006). The capital city is widely regarded as a geological marvel, sitting on some 10% of the world's oil reserves and considerable quantities of gas, while extraction costs for these resources remain among the lowest in the world. The UAE has not suffered from the instability of many of its neighbors and has 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).

The political system in the UAE does face certain challenges, including: an economy extraordinarily dependent on foreigners, who make up at least 80% of the resident population; a highly heterogeneous foreign population; a traditional and authoritarian political system governed by an oligarchy of seven ruling tribal sheikhs; uneven distribution of natural resources among its seven constituent emirates; significant differences between Abu Dhabi and Dubai in lifestyle and attitudes toward economic and social issues; and a public dispute with Iran, a vastly larger and more powerful neighbor just fifty miles away across the Persian Gulf (Rugh, 1997). Nonetheless, Rugh (1997) emphasizes that "the UAE political system is not as fragile as it might appear. Despite the factors cited above, it has, in fact, sources of strength and resilience which will probably protect it in the short run and can be mobilized by its UAE leadership to maintain the essentials of the current system even in the longer term" (p. 15). Two critical strengths are that the country produces more than two million barrels of petroleum per day, and that it holds nearly 100 billion barrels of recoverable reserves — enough to allow current production to continue for over 100 years (Rugh, 1999).

Abu Dhabi remains one of the few oil producers in the world that has responded to rising global demand by investing in new production capacity. There has also been a willingness to embrace downstream innovation through joint venture partnerships such as the Borouge petrochemicals project. Further industrial diversification on the back of hydrocarbon development is well underway, and a portion of the large oil revenue surpluses of recent years will be invested back into the domestic economy (Strong fundamentals support Abu Dhabi property, 2006).

The Abu Dhabi Securities Market (ADSM) was established by Local Law No. 3 of the year 2000 and was launched on November 15, 2000. Local Law No. 3 designated the ADSM as a legal entity of autonomous status, authorized independent finance and management, and provided the stock exchange with the requisite supervisory and executive powers to exercise its functions, which include:

Providing opportunities to invest savings and funds in securities in order to benefit the national economy; ensuring the soundness and accuracy of transactions and the interaction between demand and supply in order to determine prices; protecting investors through establishing fair and proper dealing principles; imposing stringent controls over securities transactions; developing investment awareness by conducting studies and issuing recommendations in order to ensure that savings are invested in productive sectors; and ensuring financial and economic stability while developing trading methods in order to guarantee liquidity and price stability of listed securities.

The ADSM has also been authorized to establish trading halls and branches outside the Emirate of Abu Dhabi. To date, it has established such facilities in Ras Al Khaima, Fujairah, Sharjah, Zayed City, and Al-Ain City, with a second trading hall established at the Marina Mall (Market establishment, 2007). The ADSM's board of directors consists of seven members nominated by Amiri Decree and serving a term of three years; the first board was constituted by Amiri Decree No. 8 of 2000 (Market establishment, 2007). According to the ADSM's investor guidelines, the stock exchange's trading floor is equipped with state-of-the-art technology to provide maximum liquidity in securities trading. All registered brokers have offices on the trading floor, where they are supplied with trading workstations and communication facilities to execute client orders efficiently. The trading floor is open to investors during business hours and features large television screens displaying real-time trading data (Investor guidelines, 2007).