Further, the divergence between the Saudi market and S&P 500 during the last month (TASI +10.4 percent while S&P500 was just +1.4 percent) supports Al-Rajhi Capital’s view that retail investors and speculation are driving the market as they seem to have overlooked the global macroeconomic developments.

Al-Rajhi Capital believes that retail investors prefer speculation and are willing to participate on such activity, given the scenario of a market rally and positive news flow. Though retail investors haven't responded to strong profits and cheap valuations in 2011, they have started joining the speculation bandwagon in late 2011.

Since the start of 2012, there has been a huge jump in traded volumes and value for TASI, especially for the smaller sectors like real estate, transport, and insurance. Smaller sectors have reported a 100-300 percent increase in volumes while the large sectors such as petrochemicals and banking sectors reported a rise of 40 percent and 74 percent respectively. Value traded also showed a similar trend with smaller sectors accounting for a sharp rise. This clearly shows retail investors' preference considering that these small sectors represent 8.4 percent of total market cap, while they have comprised 32.9 percent of total value traded YTD.

The year 2011 was extremely strong in terms of macro (Saudi GDP growth of 6.8 percent) and micro levels (record corporate profits). However, the equity market never responded (-3.6 percent in 2011). At the beginning of the year, the Arab spring impacted the performance but the market absorbed the negative news flow and started staging a recovery in Q2, 2011. However, the H2 performance was again overshadowed by the lingering uncertainties in the global macroeconomic environment and slowing growth from the emerging markets.

Positive news flow regarding the debt crisis in Greece and the US industrial data has resulted in improved investor optimism during the last 2-3 months.

The report said over the last 2-3 months, the volumes in Saudi Arabian market increased considerably making the rally more substantive and credible. The volumes were up 260.4 percent since the start of the year and touched 781 million on March 12, 2012, while in value terms it was at a multi-year high with value of SR16 trillion, up 193.5 percent since the start of the year. Retail investors have a dominating presence and now account for more than 92 percent of the overall volumes, which is also a multi-year record. The report said rising volumes indicate increased speculation amid upbeat news flow.

In late 2008, the Saudi Ministry of Justice started publishing weekly data on the real-estate market in Saudi Arabia. Published data includes among other things: 1) value traded, 2) number of transactions, and 3) the province of transaction. Despite the fact that the ministry only provides data of four cities - Madinah, Riyadh, Dammam and recently Al-Qatif – the report said this data provides sufficient overview of the real estate market in Saudi Arabia.

The report said in 2011, the trading was extremely dry, especially in the residential sector where number of transactions declined by almost 20 percent from 2010 levels. That said, the total value traded only declined by 4 percent, which can be attributed to inflating prices.

Swaps activity has increased sharply in the last few months with net purchases through the swap agreement reaching SR1.5 billion in February 2012, which is a record. This coupled with rumors regarding the opening up of the stock market to foreign investors has attracted retail investors to the market with increased confidence.

With low credit costs currently prevailing across the kingdom, private credits have grown sharply resulting in more liquidity in the markets.

Despite the current rally in the stock markets, TASI's valuations remain attractive as compared to other GCC markets as well as major emerging markets globally. TASI currently trades at 12.8x 2012E, at a marginal premium to major markets across the region such as Qatar (10.5x) and Dubai (10.8x). Other global markets such as India (15.2x) and the US (13.1x) are trading at a significant premium to TASI despite lower domestic growth forecasts in those countries.

The Al-Rajhi Capital report said recent rally in the Saudi market is fueled by investor optimism and a strong performance outlook in 2012.