What We Know and Don’t Know About the Saudi Stock Market

RIYADH, 13 March 2006 — For over two years, as the Saudi stock market continually broke all records way beyond any market fundamentals, the fear of a correction has haunted everyone. So, although it should not have been a surprise when it came on Feb. 26, no one is sure what lit the match and why there is so much fluctuation. Some think it was the Saudi Capital Market Authority’s (CMA’s) decision to cut the maximum daily fluctuation limit from 10 percent to 5 percent the day before; others have more sinister explanations.

Let us review the evidence. On the first two days of the correction (Feb. 26 & 27) when the Tadawul All-Share Index (TASI) dropped by a total of 1,895 points (9.2 percent), the average trade size (i.e., number of shares per transaction) dropped from 125 to 92 and then to 86. In comparison, the average trade size for February (till the correction) was 154.

Accordingly, the total trade volume and value also dropped. Data also show that on the market pullback the following day (Feb. 28), the average trade size rebounded to 150. But panic selling again took over. On March 2, when the market dropped 4 percent, the average trade size was again down to 82. What this evidence suggests is that the panic selling was done by small traders and the buying was done by big traders.

This pattern has continued in the subsequent market swings, with small trades dominating the downturn days and big trades dominating the pullback days. We don’t know what created the panic among the small traders. And, we don’t know if the pullbacks occurred because big investors were jumping in to take advantage of the lower prices or if institutional investors were stepping up to the plate to stabilize the market. We do not know how long or how deep this correction can go. But we know that the downward potential is significant.

First, because the current market P/E ratio is way over the historic norm (40+ vs. around 15), which means that the potential bottom is far below.

Second, big traders, who entered the market early, have made their money many times over (active trading and churning of trades have given them more profits that the rise of the index alone suggests) so that their bottom line is also far below.

And third, if all investors — big and small — go on the sell side then, in a market where there are no market makers, the bottom can be a long way down (unless institutional investors can be brought in to act as temporary market makers).

Unhappily, there was some evidence of some big investors selling on March 7 and 8 (and also on March 3 to some extent), when the market fell but average trade size did not fall.

The bottom line is that the stock market has become a monumental distraction for the real economy. The real economy, by all measures, remains sound and on solid footing. Last year saw record economic growth (6.5 percent), record current account surplus ($87 billion), record budget surplus (SR214 billion), strong infrastructure and project spending, accelerating economic reforms, and the crowning achievement of WTO (World Trade Organization) membership.

Yet, the rise in the market beyond any company fundamentals and its current correction is raising fears and distracting investors and observers alike. And the stock market seems to have become the only game in town.

Many individuals have pulled their savings out of banks and put it into local stocks, with many even borrowing to the limit to do so. Some companies have taken their investable funds and put them into the stock market instead of real investment. Banks find themselves facing a shortage of funds as customers not only pull their deposits out but turn around and borrow from the banks to trade stocks.

We know that the stock market boom has been driven by the huge oil export-based liquidity that the Kingdom has enjoyed in the past three years, magnified by the magic of money creation in the banking sector and the power of money in fueling economic transactions.

We know that the new wealth generated by the stock market has fueled consumption and import spending with little going into real investment, while at the same time the country seeks investment from abroad. We don’t know if the pullbacks we have seen so far signal a bottoming out of the market or if we will go the way of Dubai (correcting since last July) or Doha (downturn since October).

Market fundamentals remain the same and the bullish factor, the strong oil export-based liquidity inflow also has not changed, leaving us with no predictive power for the future. The market has reached kind of a “Twilight Zone” where investor sentiment and investor fears rule. Lack of correct information about what is going on and what authorities are doing to calm the markets is allowing rumors and misinformation to take over. We know what the solutions are but they need to be implemented quickly.

One immediate solution would be to enable major institutional investors to step in and act as temporary market makers. The ultimate solution, however, is to introduce permanent market makers, speed up the pipeline of initial public offerings (IPOs) and increase the supply of shares, increase market knowledge and transparency through the introduction of independent analysts and advisors, and impose severe and public punishment for market manipulation and insider trading.

(Khan H. Zahid is chief economist and vice president at Riyad Bank. He is based in Riyadh.)