Central Bank of Oman Occasional Paper No.

2006-2

MSM and the Efficient Market Hypothesis: An Empirical Assessment

Central Bank of Oman Economic Research and Statistics Department Post Box-1161, Ruwi-112, Sultanate of Oman Tel: 968-24702222, Fax: 968-24788513 E-mail: cboresb@omantel.net.om Website:www.cbo-oman.org

Economic Research and Statistics Department http://www.cbo-oman.org

CBO Occasional Paper No. 2006-2

Central Bank of Oman Occasional Paper No. 2006-2

MSM and the Efficient Market Hypothesis: An Empirical Assessment

Ali Hamdan Al-Raisi & Sitikantha Pattanaik

CENTRAL BANK OF OMAN Economic Research and Statistics Department Post Box-1161, Ruwi-112 Sultanate of Oman Tel: 968-24702222, Fax: 968-24788513 E-mail: cboresb@omantel.net.om Website: www.cbo-oman.org

October 2006

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FOREWORD
The movement in prices of stocks listed in the Muscat Securities Market (MSM) represents one of the most closely watched and discussed financial market variables in Oman. In view of the volatility seen in the MSM-30 Index in the recent years, quite in line with the trends in other regional and global stock markets, a common market curiosity has generally been to better understand what may be causing cycles of overshooting and subsequent corrections - if not bubble and subsequent crash in stock prices, and how could one take a view on the rational valuation of a stock. The debate on the Efficient Market Hypothesis (EMH) is extremely relevant in this context. Believers in EMH argue that market price of a stock always reflects all available relevant information that should go into valuation, and hence, the current price of a stock is its fair value. No amount of serious analysis of available information about a stock can help one in identifying the undervaluation or overvaluation of a stock as a source of excessive profit, and any extra return accruing to anybody from such market analysis could actually be a compensation for extra risk that the investor may be taking, knowingly or unknowingly. As per the other extreme viewpoint, stock prices are often driven by fads and fashions and mob psychology, quite unrelated to fundamental value-determining factors, and hence, there could be opportunities to beat the market. In this issue of the CBO Occasional Paper, Mr. Ali Hamdan and Mr. Sitikantha Pattanaik study this debate on Efficient Market Hypothesis (EMH) in the specific context of the movement of MSM-30 index over the period 1997-2006. While random-walk test equations indicate presence of serial correlation in daily return data for the MSM30 index, Auto Regressive Conditional Heteroscedasticity (ARCH) and Generalised Autoregressive Conditional Heteroscedasticity (GARCH) coefficients exhibit presence of conditional variance, which at times could be predictable, if not the return itself. Both these tests indicate rejection of the EMH for the MSM-30 index, even though there could be other rational reasons as discussed in the study yielding such results, which could in fact be found even in an efficient market. The study emphasizes the importance of information sensitive investment decisions backed by more equity research in Oman, so as to further enhance the informational efficiency of the MSM. The views expressed in this study, as is the case with all issues of CBO Occasional Papers, are of the authors and not of the CBO.

Hamood Sangour Al-Zadjali The Executive President

CBO Occasional Paper No. 2006-2

MSM and the Efficient Market Hypothesis: An Empirical Assessment

Ali Hamdan Al-Raisi & Sitikantha Pattanaik*
Efficient stock markets are often seen as the symbol of modern day capitalism. The widespread ownership of firms is also viewed as peoples capitalism, that is believed generally to enhance the role of finance in promoting real economic growth while also distributing the benefits of economic progress more widely. The rational market view even presents stock markets as illustrations of competitive markets. While Baumol (1965) had viewed stock market as a relatively close approximation of a perfect market, both Alfred Marshall, the founder of partial equilibrium analysis, and Leon Walras, the founder of general equilibrium analysis, had cited stock market as a real-world case of a competitive market. Competitive stock market was viewed as essential in neoclassical economics for encouraging capital accumulation and allocating the capital to socially optimal uses. In a competitive market it is the pricing mechanism which holds the key, and in respect of a stock market, the price of a stock is always believed to be informationally efficient. The efficient market hypothesis, thus, suggests that the market price of a stock reflects all available information, leaving thereby no scope for yielding excess returns through massaging of any market information. Informational efficiency does not allow anybody to consistently beat the market, and higher returns in such markets can result only from exposure to higher risks. The efficient market hypothesis (EMH) for common stocks has received significant empirical support in the past, and as noted by Jensen (1978), there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis. At the other extreme, there is another equally strong view which suggests that stock markets are paper casinos, where greedy and often ignorant small investors tend to loose in the process of following the market trends. Speculation driven markets, as emphasized by Keynes, Veblen, Galbraith and Shiller, have little to do with efficient pricing of new information. As per the Marxian interpretation, stock movements and transfers reflect the result of gambling at the stock exchange, where the little fish are swallowed by the sharks and the lambs by the wolves. The markets, according to such views, are driven by investors fads and fashions, instead of economic fundamentals. Pure speculation, that often dominates such markets, is a psychological phenomenon, where one may buy stocks purely on the basis of expectations and behaviour of other market participants. As noted by Keynes (1936), people in general could be too timid, greedy, impatient or nervous about their investment to take long-term views on valuation, and it is their zest for making
*

The authors are grateful to both the Capital Market Authority (CMA) and the Muscat Securities Market (MSM) for their encouragement and support. The views expressed in this paper reflect the personal research findings of the authors, and errors in the paper, if any, should be ascribed to the authors only.

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money quickly that the spontaneous mob optimism mostly drives the stock markets. Such short-term mob expectations are not based on information, but on what average opinion expects the average opinion to be. When the market is driven by short-term mob psychology, even the very few long-term investors may join the bandwagon to avoid the risk stemming from a policy of going against the market. In the context of this long standing debate between the rational market view holding the supremacy of market efficiency, and the other extreme view suggesting the predominant role of mob psychology and speculation in a market, empirical research on the subject stands quite divided. This debate merits a specific revisit in the context of the recent volatility that has been witnessed in the stocks trading in the Muscat Securities Market (MSM). Following the strong bullish trend in regional stock markets, and supported by the initial enthusiasm about Omantel, the MSM 30 index exhibited a major surge till the mid of 2005, which was subsequently taken over by a notable correction in the first half of 2006, again reflecting the global and regional market trends as well as the tapering off of strong expectations from the Omantel. While in just one year time the index jumped by 57.6 percent (i.e. end of June 2005 over end of June 2004), in the next one year the index fell by 10.8 percent (i.e. end of June 2006 over end of June 2005). The most startling aspect during this phase of up-down cycle in the stock market in Oman has been that the macroeconomic conditions continued to remain rather strong and resilient, implying that the volatility in MSM was not reflective of the macroeconomic conditions prevailing in the country. This phase of falling stock prices in oil dependent Gulf economies in the face of high oil prices has also been viewed as the Gulf conundrum, which calls for a realistic assessment of the informational efficiency of these markets. Against this backdrop, this study empirically evaluates the informational efficiency of the MSM, and while narrating the theoretical and empirical debate on the subject, it also aims at highlighting the important role of both informed investors and greater equity research in further enhancing the efficiency of the market. The concept of efficiency used here relates to informational efficiency and not allocational efficiency. The scope of the study is limited to empirical assessment based on available data for the MSM. Section-I outlines the debate on efficient market hypothesis, which is often overlooked by uninformed investors in their search for high returns. The performance of the MSM in the past several years is reviewed in Section-II. The empirical estimates of market efficiency for the MSM are setout in Section-III. SectionIV contains a few concluding observations.

Section-I: The Efficient Market Hypothesis Debate While walking on the Al Markazi street if you find a RO 50 currency note lying unpicked by anyone else prior to you, an economist would immediately advise you not to bother, since if it were a genuine RO 50 bill, then some body else before you must have picked it up. The efficient market hypothesis is often best explained with such a simple example to make the point clear to the investors that there is no new information that can help them in beating the market, since an efficient market prices all new information rapidly, leaving 2

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little scope for anybody to reap excess returns on a consistent basis. Based on the assumption that market prices fully incorporate expectations and information of all market participants, three forms of market efficiency are commonly discussed in the literature. Weak form efficient market hypothesis suggests that current price of any asset does not contain any information that can be useful to predict the future price behaviour. As per this view, any technical analysis or fundamental analysis that aims at predicting the future course of market prices from past data, cannot yield correct results (such analyses are ok as long as one may be selling those ideas instead of using himself). Semi-strong form efficient market hypothesis states that all publicly available information such as financial statements, strategy and past history, etc. are fully reflected in the current price of the asset. Event studies, that track the price developments before and after the announcement of such information, often help in assessing how quickly any new information gets priced in the market (in fact the market discounts most of the new information much ahead of the actual release of the information, starting from a change in the interest rate to announcement of dividends). Strong form efficient market hypothesis advocates that all public as well as private information are fully reflected in the price and, therefore, agents having even inside information cannot constantly beat the market. Fama (1970, 1991). Lo and MacKinlay (2002) raised the most valid empirical question as to whether it is possible for stock market prices to be predictable to some degree in an efficient market?. They explained succinctly that if the prices are not forecastable, that is not always an indication of efficiency, and similarly, market efficiency does not necessarily mean that prices cannot be forecasted. As per their practical version of the efficient market hypothesis, it could be difficult, though not impossible, to generate consistently superior returns in a market. Such beating the market performance could arise from some competitive advantage associated with superior information, superior technology, financial innovations, etc. In an efficient market, thus, the only way to earn positive profits consistently is to develop a competitive advantage, in which case the profits may be viewed as the economic rents that accrue to this competitive advantage. If the markets were perfectly efficient, then return to information gathering and analysis could be zero. In practice, investment on information gathering and analysis helps in generating higher returns in relation to what the efficient market hypothesis would suggest, and hence, the profession of financial analysis has become so lucrative over the years. Higher profits resulting from investment on information gathering and analysis, thus, represent economic rent arising from activities that enhance the competitive advantage. The most relevant related question then is who pays these rent in a competitive market. According to Black (1986), it is the noise traders, who trade on noise rather than fundamental information, pay such rent. This line of assessment clearly sends a warning signal to investors who trade on pure noise and completely ignore the importance of information and fundamental value analysis. There is an equally strong counter view which almost ridicules the practical relevance of analysis driven investments. Ashley (2003) noted in this context that much of what is said and written about in financial markets is often dreadful rubbish. As we all know, the truth does not count in finance, its what everybody else believes that is important. When the market is dominated by 3

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speculators aiming at maximizing short-term profits, more than anticipating the extremely difficult future earnings prospects of a stock, the analysts, like any other common investors, tend to anticipate the much easier mob psychology. Emphasizing the role of mob psychology on the behaviour of uninformed investors, and hence the markets, Keynes(1971) noted that the ignorance of even the best-informed investors about the more remote future is much greater than their knowledge. If even the best informed are completely informed, the vast majority of people buying and selling securities make their decisions without possessing even the rudiments of the knowledge required for a valid judgement. In such a state of ignorance, they are prey of hopes and fears that are easily aroused, and just as easily dispelled, by transient events. The so called best informed may often profit by anticipating mob psychology rather than the real trend of events. Mob psychology assumes such great importance because of the dominance of financial professionals and speculators, with very short investment horizon but high return expectations. Such investors do not intend to stay invested in any stock for long, and are constantly in search of an opportunity to resell the stock to the mob. Every buy and sell decision, thus, requires predicting the mob psychology. The markets are accordingly driven by what average opinion expects the average opinion to be. In hindsight, the experience with Omantel IPO in Oman somewhat vindicates the role of mob psychology in the stock market. But history is replete with such examples. Prior to bursting of the technology bubble in the late 1990s, for example, Lowenstein (1996) wrote that investing in stocks has become a national hobby and a national obsession. People may denigrate their government, their schools, their soiled sports stars. But belief in the market is almost universal. To update Marx, it is the religion of the masses. The bigger fool syndrome often gives rise to stock market bubbles, and eventual crashes, clearly unrelated to fundamentals. Surowiecki (2004), who strongly believes in the wisdom of crowds, also recognizes that bubbles and crashes are textbook examples of collective decision making gone wrong. Bubbles are typical characteristics of a stock market because of the bigger fool syndrome, that is, one may purchase a stock at a high price because there will be somebody else (i.e. the bigger fool) to buy at an even higher price, irrespective of the fact that both prices may be quite unjustified in terms of underlying fundamentals. This does not happen in markets for goods and services ( i.e. nobody buys a car, TV or a cell phone with the only intention to resell at a higher price, and even when one wants to resell after use for some time, it would be quite difficult to get bigger fools like what one may get in case of stocks). Because of the presence of bigger fools, stock prices tend to overshoot the fair value. Unlike goods and services market, of course, there is always uncertainty about the valuation of a stock. However, even when full information is made available (through an experiment with known dividend flows for the number of years up to which a firm may remain in production), market prices may still exceed the discounted present value of all known dividend earnings, because of the bigger fool syndrome. Unlike periods of orderly market behaviour when expectations are more uneven, during periods of bubbles and the eventual corrections expectations increasingly converge and become unidirectional. According to Surowiecki (2004), a market, in other words, turns into a mob. When the market is driven by mob 4

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psychology, there may be complete disregard for information. As highlighted by Fisher (1930), four factors may justify a rise in the price level of stocks: (a) earnings are continuously ploughed back into business instead of being declared as dividends, resulting in an accumulation for future growth, (b) expected earnings increase on account of technical progress, (c) earnings are viewed to be less risky than what was perceived earlier, and (d) change in the rate of discount (i.e. interest rate/cost of capital to the firm) used for discounting future earnings into the present. During a bubble, expectations about future earnings may be revised upwards or the earnings may be viewed as less risky in relation to the past. But beyond a point, it is pure mob psychology which takes over. As pointed out by Ashley (2003), it is not just our own judgments that finally decide whether we make an investment decision; we need to cluster around others opinions for confirmation. In fact we are very much influenced by those around us. It is easier to join the crowd than fight it. Despite the practical significance of Keynesian mob psychology in relation to fundamental value analysis, Keynes has often been viewed, as noted by Raines and Leathers (2000) as a bubble theorist who saw all stock markets as simply gambling casinos. In modern day capitalism, stock markets are rather seen as the key vehicle for mobilization and allocation of resources. Enhancing the efficiency of the markets, thus, continues to dominate the policy thinking all over the world. Since generation and processing of information could be costly, prices need not necessarily always reflect all available information, because that would leave little incentive to invest resources on acquisition of information and their analyses. Informed market players, who compete to acquire and analyze new information, hold the key to develop an efficient market because despite the presence of profit opportunities arising from mob behavior, it is only these players in the market who tend to correctly process and price information. Investors relying on such analyses, however, must recognize the distinction between knowledge power and an impressive power point presentation. This is because identifying the intrinsic value of a stock, and hence the undervaluation or overvaluation of a stock, is an extremely difficult task. There may be either too much or too little information, but more than that, there may be too little knowledge to use the available information appropriately. As per the efficient market hypothesis (EMH), however, the current price of a stock itself is the fair valuation of the stock. Hence, the old Wall Street adage suggests that the value of any stock is only what someone is willing to pay for it (i.e. its current price). The bigger-fool concept also reckons that as long as a stock can be sold at a higher price to another, that would represent the intrinsic value of the stock at that point of time, and no high price could be seen as an overvaluation. In practice, in every market, one also comes across assessments of overheating and corrections, with reference to perceptions about fair value. In the search for correct valuation, one often comes across the debate between fundamental value analysis and technical analysis, both of which aim at identifying stocks that may be overvalued or undervalued. Under technical analysis, there is no search for any elusive intrinsic value of the stock. The search is only for trends/patterns in evolution of stock prices, which could be picked from past price behaviour, and which could be expected to recur in future. Investors who 5

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are active in trading and frequently change positions over short time horizons, picking of trends through charting may help. At times, even when the trends may not recur, and accordingly predictions may go wrong, with cut-loss strategy such investors can exit their positions. Even though in an efficient market trend analysis through charting should not leave any scope for excess returns, use of technical analysis is quite common in markets, which suggests that imperfections identified by chartists may be helping in enhancing the efficiency of the market. In that sense, the fair value of a stock is rediscovered again and again, with corrections taking place to the valuation at every stage. Unlike technical analysis, fundamental analysis aims at identifying the intrinsic value of a stock so as to be able to pick stocks on the basis of overvaluation or undervaluation in relation to the intrinsic value. As per this analysis, a company is worth the sum of all its future cash flows discounted to the present. If the present value exceeds prevailing market capitalization of the company, then the stock could be a good buy. In such analyses, expected future earnings/cash flows and the discount rates could change from time to time, causing the intrinsic value of stocks to also change. Investors interested in value stocks, growth stocks, or income stocks (depending on individual risk appetite and investment horizon) could also supplement the value analysis with assessment of indicators such as price to earnings ratio, price to book ratio, dividend payout ratio, dividend yield, projected earnings growth, etc. As per the top-down approach, the fundamental analysis often may start with the performance and prospects of the economy, followed by the industry group, and finally the firm within the group. Such three level analyses necessary to assess the prospects of any single stock could be resource and time intensive, and the return on such investments on information gathering and analyses should be positive, even in an efficient market. There is no apparent contradiction here, since one may not benefit from any new public information as per the efficient market hypothesis, but money spent on acquisition and analysis of information must be recovered in the form of higher return. Thus, those who try to remain informed and in that process spend resources must be adequately compensated in the form of higher return than those who do not spend on information and tend to free ride. A market in fact can become increasingly efficient only because of the costs incurred on acquisition and analysis of information. This signifies the importance of equity research in enhancing the efficiency of a market. In a competitive information collection system no excess returns could be earned from new information per se, but higher information gathering and processing costs must be exactly compensated by higher return. In competitive equilibrium, thus, the marginal return from additional information should equate marginal cost of information acquisition. If the information collection and analysis system in a country is not competitive, free riders can benefit at the expense of those who invest on information acquisition and analysis. In such systems there may be little incentive to invest on market research, and as a result, speculation and mob psychology could dominate the markets. Supporters of efficient market hypothesis may recognize the importance of market research for enhancing efficiency of the markets, but superior analysis and research need not be a source for yielding consistently higher returns. As per this view, those reaping higher returns through superior processing of all available past information may actually be exposing them to higher risk and, 6

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as a result, the higher return must be a compensation for the extra risk they bear unknowingly. The risk-return tradeoff is a fundamental factor in an efficient market. The required rate of return (RRR) on equity is much higher than other financial instruments because of the higher risks associated with equities. Thus, higher return on equity could be viewed as compensation to the investors for assuming higher risk. But the key question here is by how much the required rate of return on a particular stock should exceed the return on risk free instruments like Government Bonds and Treasury Bills? As per the Capital Asset Pricing Model (CAPM) framework, total risk of any project could be decomposed into systematic and unsystematic risks, so that [total risk = unsystematic risk (or idiosyncratic or diversifiable or firmspecific risk) + systematic risk (or non-diversifiable or market risk)]. Unsystematic risks can virtually be eliminated through diversification, and investors who do not hold a diversified portfolio of stocks must not expect to be compensated in the form of higher return on equity for assuming nonsystematic risk of a firm. As per the portfolio selection models of Markowitz, Sharpe and Lintner, diversification can compress the risk levels of portfolios (measured as variance-covariance of returns) for specific return levels. In the CAPM framework, investors care only about mean return and the variance of the return. Firm specific unsystematic risk could be contained through diversification, and for given degree of risk aversion, efficient portfolios could be constructed using the portfolio selection models, so that risk is minimized for given levels of return, or returns are maximized for given levels of risk. Investors, however, must have to be compensated for assuming systematic risks when they invest in stocks. An appropriate risk premium, representing additional return over the risk free rate, must be offered to induce risk averse investors to take equity stakes in riskier projects. CAPM beta helps in offering an appropriate estimate of risk premium in relation to a project's exposure to systematic risk. The tradeoff between systematic risk () and expected return is generally captured through the upward sloping security market line (SML). Any stock with a higher beta must fetch higher return than the return on the broad market portfolio. The beta () of a firm could be estimated through linear regressions (i.e. regression of individual equity returns over the returns on overall market index, both adjusted for risk free rates). According to CAPM, the only relevant measure of systematic risk of a project/asset class is (). In efficient markets, thus, higher returns could be possible only because of exposure to higher risks. Thus, an extremely rigid interpretation of market efficiency would suggest that return to investment on equity research could be zero, since in such markets there is no scope for value addition by portfolio managers and investment analysts/strategists. A more practical interpretation, however, would suggest that market efficiency is achieved and continuously enhanced only through investment by investors on information collection and their analyses. Only such informed investors contribute to market efficiency who recognize potential undervaluation and overvaluation of stocks, reap excess returns till others also recognize it, and keep investing till the inefficiency in valuation disappears. One could infer, therefore, that return to equity research is positive till the market remains inefficient, and at every level of efficiency of the market, equity research further enhances efficiency. Market efficiency, thus, is 7

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an evolutionary process, where every incremental progress is made possible through better collection and analysis of information.

Section-II: The Past Performance of the MSM The performance of a stock market from the stand point of a lay mans perspective often relates only to the return it can generate on investments. A friendly chat with most investors in the MSM would reveal their excessive emphasis on return, and clear neglect of many other important aspects about the stocks they hold in their investment portfolios. The years in which returns are good, the market is viewed as performing well, and the moment returns turn negative or remain below high levels of expectations, the market is seen as a source of misery. This single dimensional focus on return clearly overlooks the long-term performance and prospects of the firm, the industry group and the overall economy. Such short-term earnings centric market perception is fraught with the risk of corporates also targeting primarily quarterly earnings figures, which could be achieved at times by resorting to creative accounting. Even in advanced markets this tendency has triggered greater attention of regulators, including Acts such as the Sarbanes-Oxley in the US. The investors need to recognize that the value of a firm may change from time to time due to several firm specific, industry specific or economy specific developments, and at times there could be transmission of shocks from regional and global stock markets. The performance of a stock market at the macro level, thus, could be appropriately assessed in a multidimensional framework, focusing on market size, degree of market concentration (in stocks), liquidity, volatility, transaction costs, level of integration with world markets, etc.. These performance indicators must also be seen in the context of market driving factors like the increases in real income, domestic saving, capital inflows, domestic liquidity positions, market deregulation and supervision, etc. At the micro level, firm specific indicators like net present value (NPV) of the firm, price to earnings (P/E) ratio, earnings per share (EPS), price-to-book value of the share, dividend yield and dividend payout ratios, etc. are also often seen for identifying undervaluation and overvaluation of stocks. Certain empirical analyses suggest that small company stocks can earn higher return than large company stocks, and value stocks with low market-to-book and low P/E ratios can outperform growth stocks with high market-to-book and high P/E ratios. Advocates of efficient market hypothesis, however, would argue that those who pick stocks on the basis of such firm specific factors actually expose themselves to higher risks, and the higher returns that they may reap could in fact be a compensation for the extra risk they bear. In Oman, the Muscat Stock Market (MSM) has a short history of less than two decades, and during this short history also there was one major confidence shattering fall in the market in 1998, which continues to reverberate in the market memory even today, not dissuading the investors though from joining the strong rally in the market that was witnessed till the mid of 2005. The strong rally in the market received the push from the overall brighter macroeconomic conditions made possible by surge in oil prices and the 8

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associated easy liquidity conditions, better performance of the non-oil sectors, further progress on diversification and privatization, improved profitability of corporates and banks, as well as self-fulfilling investor expectations of even better return prospects in future on account of every likelihood of the economic boom being sustained in the future. The initial enthusiasm, which may be driven by fundamental factors, often ends up in exuberance, and as a result, as noted by Shiller, investors do not just turn irrational, but turn irrational in predictable ways, overreacting to any positive information by buying in herds. The bubbles, thus, though start with a rally driven by fundamental factors, soon get taken over by mob psychology and herd behaviour of investors, and the more the bubble grows in size, the extent of market correction that follows may also become equally sharp. This market driven process of overheating and subsequent correction ensures eventual alignment of market value of stocks with their respective fair values. In Oman, the macroeconomic conditions continued to remain robust in the second half of 2005 as well as the first half of 2006, as was the case during 2003-05 when the MSM witnessed strong rally. The fall in the index since mid-2005, despite strong macro fundamentals, could be viewed as a correction for the overshooting that had occurred during the rally period. As could be noted from Table-1, the annual growth in the MSM index exceeded the nominal GDP growth by a wide margin during the 2002-2005 period. The growth in the index even exceeded the rate of increase in prices of Omani crude during this period. Such a high rate of return (capital appreciation plus annual dividend yield) clearly reflected the growing influence of irrational exuberance on the market up to mid 2005. Any rational assessment of expected return on stocks would suggest that given a risk free return of less than 5 percent in the system (say a long-term deposit or investment in Government bonds), even if one assumes a risk premium of 15 percent, any annual return in excess of 20 percent on stocks on a sustained basis must be looked with suspicion by rational investors. How can potentially a firm generate such high returns on any type of business activity, unless it is exposed to high risk. In terms of CAPM beta, a single firm with high risk (beta) in relation to the market may yield higher return, but the market as a whole (as represented by the MSM index) cannot be expected to yield high returns (capital appreciation plus dividend yield) when the overall economic performance, despite being strong, cannot justify that. This begs the question as to whether informational inefficiency (i.e. market not reflecting the available information about fundamentals correctly) is a major reason for such large swings in market prices in the face of a stable behaviour of both the economy and the firms whose shares are listed on the market. Most advanced stock markets in the world have witnessed phases of strong boom-bust cycles in the past, and most recently the entire GCC region witnessed a phase of strong rally followed by sharp corrections. The empirical assessment of informational inefficiency of a market, thus, is a very daunting challenge, since for every staunch supporter of market efficiency, every prevailing price is a fair price. One has to see, therefore, first whether a market meets the requirements of a competitive market place, and second, whether a market can mature to that stage only over time. For efficient market conditions to prevail, several preconditions may have to be fulfilled, such as: (a) large number of rational, profit maximizing investors 9

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who actively participate in the markets based on informed analysis and valuation, (b) flow of information is symmetric and random and unrelated over time, and (c) market agents react quickly and accurately to any new information, causing the prices to instantly reflect any new information. Whether MSM fulfills these requirements is again difficult to assess. What is learnt from experience of other advanced stock markets, however, is that markets mature over time and preconditions to efficiency are attained only gradually, and possibly never attained fully, leaving scope for detection of market anomalies as a source of excess returns in every market. Since it first started its operations on May 20, 1989, the MSM has come a long way, with notable growth in market turnover, market capitalization, number of market players, and number of issues (Table-1). In the context of an assessment of the informational efficiency of the market, each specific aspect of the progress achieved in the MSM could count. Market liquidity (which is different from monetary liquidity conditions managed by the CBO) has been one such important aspect. A stock can be termed as illiquid, if it is difficult to sell it at unchanged price, or if it can be sold only at a lower price. Illiquidity of a stock market depends on: (a) width of the market, (b) depth of the market, and (c) resilience of the market. Width implies the extent to which prices may change in response to any purchase/sale of stocks (i.e. higher the change in price for any given buy/sell order, the more illiquid is the market). Depth of the market implies trading volumes that can settle without altering the price (i.e. if large volumes of the same stock can be sold at unchanged price, then the stock can be termed as liquid). Resilience refers to the speed at which price volatility resulting from trading activities settles down (i.e. in more liquid markets large volumes of trade may affect prices only very temporarily). In general, thus, a stock market can be termed as liquid if stocks can be bought/sold in any quantity without little impact on market prices. In that sense, can the MSM be viewed as illiquid (despite easy monetary liquidity conditions maintained by the CBO)? The answer could be in the affirmative, since the MSM lacks depth, width, as well as resilience. The low depth of the MSM is evidenced from the sharp decline in the turnover for MSM-30 since August 2005 (as against the turnover of RO 170 million in August and a little more than that in July, the turnover in Sept and Oct. were much lower at RO 103 million and RO 99 million respectively). Moreover, the average daily turnover is yet to reach the peak attained way back in 1997 (Table-1). The low width of the market is evidenced by the fact that the decline in turnover since August 2005 has clearly pulled the MSM index down substantially, from a peak of 5699 on June 20, 2005 driven by Omantel frenzy, to below 4800 in December 2005. (Despite subsequent recovery to above 5500 in early 2006, the market generally remained subdued and fell below 4700 in July 2006. Since then the market has picked up, and gone above 5500 again in October 2006). The evidence of decline in volume affecting the index, thus, is clearly visible (even though falling index itself may also cause the turnover to decline). The MSM also lacks resilience because the fall in the MSM index resulting from the drop
Various publications of MSM/CMA document the historical evolution of the market with relevant facts and figures, including new initiatives launched by both CMA and MSM every year during this evolutionary process. To avoid repetition, and to retain focus on the subject of market efficiency, this paper does not reproduce those aspects of the market here.

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in turnover does not seem to be temporary. This illiquidity problem of the MSM could be a structural problem of the stock market itself. To deal with the structural illiquidity problem of the MSM, what may be required is the presence of large number of institutional market makers and hedge funds. Unlike brokers (who only deal on behalf of customers by charging commissions), market makers trade on their own books with large buy/sell orders offering frequent quotes in the market. Absence of institutional market makers in the face of a generally bearish market sentiment can only further aggravate the problem of illiquidity in the MSM. On a comparative basis also, the MSM market capitalization remains the lowest among the markets of six GCC countries, with a share of just about 1 percent in total GCC market capitalization of USD 1.1 trillion in 2005. Strong cumulative rally during 2003-05 was a major economic event in all the six GCC countries, as was the case with subsequent market corrections during 2005-06 (Table-2). Excluding only the pattern of movements in stock prices, there have been wide differences in the depth and width of markets across GCC countries. The depth, width and resilience of the MSM, however, need to improve considerably, which as mentioned earlier, could happen only over time. The existing market structure of the market reveals that there are large differences in the performance of individual firms listed on the MSM. Based on the available information on about 130 such firms for 2005, the distribution patterns of price to earnings (P/E) ratios, earnings per share (EPS), price-tobook ratios, annual dividend yield and extent of appreciation in stock prices during 2005 are presented in Chart-1 to Chart-5. Stock evaluation for many investors often revolves around the companys earnings. Earnings represent the companys profit, i.e. how much money it makes in any given period. Current earnings may contain leading information about how much the company can pay as dividend in the near term, and how much scope could be there for capital appreciation in the form of higher stock prices. The more useful indicator, however, is earnings per share or EPS (i.e. total earnings divided by the number of outstanding shares). A company may have large absolute earnings but at the same time the number of shares could also be large, as a result of which the EPS may not by high, whereas another company with lower absolute earnings may have higher EPS because of lower number of shares. Price-to-Earnings (P/E) Ratio is another useful indicator for stock picking as it shows the relationship between the stock price and the companys earnings (P/E = Stock Price / EPS). For example, a company with a share price of RO 4 and an EPS of 0.400 (or 400 baisa), the P/E would be 10 (i.e. 4 / 0.400 = 10). Even though there is no thumb rule, a high P/E may mean that the stock is overpriced, while a low P/E may mean that the stock is under priced. This type of stratification of stocks is too simplistic, since a high P/E may also reflect the market perception of strong future earnings growth (and hence could be a good buy), and similarly, a low P/E may mean weak earnings prospects for which the stock is generally not viewed positively in the market (as opposed to being viewed as under priced). The right P/E, thus, could be person specific, based on his analysis of earnings prospects, and may depend on his willingness to pay for earnings. The more you are willing to pay for the stock, it implies that you believe the company has good long term prospects. Some other investors, however, may not see the same value in the stock and may consider the same P/E level as high enough and thereby avoid a buy recommendation. In the case of use of indicators like EPS and P/E, the other 11

CBO Occasional Paper No. 2006-2

Chart-1: Price to Earnings (P/E) Ratios (2005)

60 40 20 0 1 -20 Firms Listed on MSM 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121

Chart-2: Earnings Per Share (EPS) in 2005

2

0 1 -1 Firms Listed on MSM 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121

Chart-3: Price to Book Ratios 2005

5 4 3 2 1 0 1 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121 Firms Listed on MSM

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CBO Occasional Paper No. 2006-2

Chart-4: Dividend Yield (2005) (Dividend paid as % of Market Price of the Stock)
15.00 10.00 5.00 0.00 1 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121 Firms Listed on MSM

Chart-5: Capital Appreciation

(% Increase in Market Price of Stocks during 2005)
100.00 75.00 50.00 25.00 0.00 -25.00 1 -50.00 Firms Listed on MSM 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121

Chart-6: Dividend Payout Ratios for 2005

100.00 80.00 60.00 40.00 20.00 0.00 1 9 17 25 33 41 49 57 65 73 81 89 97 105 113 121 Firms Listed on MSM

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Table-1: Performance Indicators of the MSM over the Past Years

1997 Amount Mobilsed through the capital 373 market*( RO million) Market Capitalization (RO million) 3339 Ratio of market capitalization to 0.55 GDP (%) Average Daily Turnover (RO 6.6 million) The turnover ratio (i.e. turnover as % 0.48 of market capitalization) MSM 30 Index** 4805.8 Annual growth in index 141.0*** Nominal GDP growth in Oman 3.7 Average price of Omani Crude($/bbl) 18.62 1998 440 2266 0.42 3.7 0.40 2248.7 -53.2 -11.1 11.92 1999 189 2262 0.37 1.0 0.11 2502.6 11.3 11.5 17.35 2000 77 1948 0.26 0.9 0.11 2012.0 19.6 26.5 26.71 2001 155 1722 0.22 0.7 0.10 1520.8 -24.4 0.4 23.00 2002 211 1984 0.25 1.3 0.17 1918.6 26.2 1.9 24.29 2003 385 2790 0.33 2.4 0.21 2726.7 42.1 7.2 27.84 2004 340 3587.5 0.38 3.1 0.21 3375.1 23.8 13.7 34.42 2005 678 5878.5 0.50 5.5 0.24 4875.1 44.4 24.0 50.26

* Include mobilization through IPOs/bonds, new listings, rights issues, private placement, bonus issues, as well as GDRs. ** The MSM Indices are presented in 1000 points scale with effect from June 01, 2004 as against the earlier 100 points scale. The past indices have been adjusted for the scale effect to maintain consistent comparability in the time series data for stock prices. ***This high rate of increase was over and above the 26 percent growth seen in 1996. The Index peaked at 5028.7 (502.87 in old scale) in January 1998 (on daily basis the peak was at 5098.4 on February 03, 1998), and fell to as low as 2091.6 (209.16 in old scale) by March 1999, representing a fall by as high as 58.4 percent over little more than one year period. But for some recovery up to 2922.7 by July 1999, the bearish market sentiments generally persisted, leading to further steady decline in the index up to 1520.8 in December 2001. Since then, however, there has been a strong recovery, with annual appreciation in the index exceeding the nominal GDP growth in each year. Driven by the Omantel optimism, the index peaked again at 5699.3 on June 20, 2005, to be followed by notable correction dragging the index to about 4741 by mid-December 2005. The index staged a sharp recovery to above 5500 in January 2006, but generally remained subdued thereafter and fell below 4700 by July 2006. Since then the index has again witnessed a major recovery, crossing 5500 mark by mid of October 2006.

14

Table-2: Comparative Performance of the GCC Stock Markets Percentage gain/loss in the market index High/Low of the Index during the last one Year* 2004 2005 2006* High Low Oman 23.8% 44.4% 14.1% 5,563.85 Muscat Securities Market (MSM-30) (09/10/06) Bahrain 32.8% 23.8% 1.6% 2,401.66 Bahrain Stock Exchange (BSE) (17/11/05) Kuwait 33.6% 78.6% -9.6% 12,106.20 Kuwait Stock Exchange (KSE) (06/02/06) Qatar 64.5% 70.2% -32.2% 12,673.10 Doha Securities Market (DSM) (12/10/05) U.A.E. 74.8% 69.4% -33.0% 5,797.07 Abu Dhabi Securities Market (ADSM) (12/11/05) Saudi Arabia 84.9% 103.7% -34.1% 20,966.58 Tadawul All Shares Index (TASI) (25/02/06) U.A.E. 186.4% 119.9% -57.3% 1,267.32 Dubai Financial Market (DFM) (9/11/05) *: Up to mid October 2006. Figures in the parentheses/brackets are the respective dates on which indices reached yearly high and low. Sources: GulfBase and MEBC. 4,643.41 (25/07/06) 1,966.68 (27/06/06) 9,227.80 (02/08/06) 7,110.11 (24/05/06) 3,277.61 (11/05/06) 9,741.43 (11/05/06) 391.54 (30/07/06)

% fall in Yearly Low in relation to High -16.5% -18.1% -23.8% -43.9% -43.5% -53.5% -69.1%

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CBO Occasional Paper No. 2006-2

important information in stock analyses is Projected Earnings Growth (PEG), since stratification of stocks into undervalued and overvalued could be based on ex-ante PEG, for given ex-post EPS and P/E. In respect of firms listed in the MSM, as could be seen form Chart-1 and Chart-2, most of the P/E ratios are within 20 (excluding stocks of exceptionally high P/E ratios, and also those with negative earnings) and the EPS for most stocks are less than 0.5 (excluding few stocks with exceptionally high EPS, and also those with negative earnings). The extent of variation across firms also suggests that for any given projected PEG by any analyst, the stocks can be stratified into undervalued and overvalued categories. It may be noted that in the case of young start-up companies, there may not be any earnings history, even though their future growth prospects could be high (as was the case during the early phase of the IT boom of the 1990s for IT stocks). Price to Sales (P/S) ratio could be more appropriate in such cases, as a low P/S may indicate good value for a new company (i.e. current high sales volume may suggest the prospects for market price of the stock to increase in future). Price-to-Book ratio is another useful indicator which suggests the value that the market places on the book value of a company (calculated by dividing the current price per share by the book value per share). Like the P/E, a low P/B may mean a preferred buy option. As could be seen from Chart-3, for most of the firms listed on the MSM the Price-to-Book ratios hover around or are less than 2, and in rare exceptional cases only P/B ratios of more than 4 could be observed. The macro and micro level information could complicate further the assessment of the performance of the MSM, because based on the strong rally in MSM index in general during 2003-2005, at the macro level the inferences could suggest overheating, whereas based on firm specific low values of P/E and P/B, it may appear that most stocks may still have scope for further growth. This again underscores the importance of greater focus on equity research, so that the investment decisions could be based on analyses of developments in the economy, industry group, as well as the individual firm, and such informed investment decisions can add to the efficiency of the market. Most stock prices respond significantly to announcement of dividends. Hence, Dividend Payout Ratio (DPR) and Dividend Yield represent two other performance indicators which are often monitored by the stock investors. The DPR could be calculated by dividing the annual dividends per share by the Earnings Per Share (or simply, total dividends paid by a firm divided by its total profits). For firms with good growth prospects, they may retain a larger part of total earnings (or profits) for reinvestment, and hence DPR may be low. In turn, for matured companies with not much growth prospects, a higher part of the earnings may be paid out as dividends, yielding a high DPR. Even though according to Modigliani-Miller (MM) proposition-2 dividend policy does not matter for value of a firm, in practice declaration of dividend significantly influences the price of stocks, creating competitive pressure on all companies to announce high dividend, despite their varied future growth prospects and the associated varied needs for retaining parts of current profits for reinvestment. Dividend yield could be calculated by dividing the annual dividend per share with the current stock price (depending on the price at which a stock is bought, dividend yield could vary from person to person, but for analytical comparison purpose prevailing market price could be used to 16

CBO Occasional Paper No. 2006-2

derive the respective dividend yield rates). A low current dividend yield has to be seen in the context of future growth prospects; if a major part of profit is retained by the company for reinvestment so as to be able to fully exploit the future growth opportunities, its stock could still be considered as a good buy despite low current dividend yield. Under a competitive dividend payout policy of firms in a market, however, low current dividend yield has to be assessed more carefully. As could be seen from Chart-4 and Chart-5, the dividend yields of firms listed on MSM have mostly been around 5 percent or less in majority of the cases, barring few exceptions with higher dividend yields, but price appreciation fetched much better return to the investors in 2005, exceeding even 50 percent for several firms. The dividend payout ratios varied widely (Chart-6), ranging from very low to very high, but the combined return in terms of both dividend yield and price appreciation of the stocks generally turned out to be quite high in 2005. In respect of each and every firm specific indicator, the investors need to keep one major caveat in perspective is that there is no thumb rule or benchmark against which stocks can be assessed as undervalued or overvalued.

Section-III: Empirical Assessment of the Market Efficiency Hypothesis for the MSM The most common test of weak form of market efficiency is the random walk hypothesis, which states that successive price or return changes are independent over time, and that the actual price hovers around a fundamental value. In a random walk framework, any market price pt = pt-1 + t , so that pt = t is an independent and identically distributed sequence. In other words, if prices fluctuate randomly, then they are not predictable. Lack of predictability as a test of weak form efficiency has generally spawned a number of empirical literature based on tests of random walk properties of the stock prices. The efficient market hypothesis does not require the market price of a stock to equal the true value of the stock, but the errors must be unbiased so that deviations in market prices from the true value are random and unpredictable. Market price, thus, is an unbiased estimate of the true value of the stock. Since it would be difficult to say at any point of time whether a stock is overvalued or undervalued, no profitable investment strategy can be formulated based on analysis of past historical data. It is important to recognize the very important differences between martingale, random walk, and efficient market hypothesis. In the case of a martingale, pt = pt-1 + t, so that rt = (pt - pt-1) = t .(a) As per a martingale process, return (rt ) varies around zero, with t having zero mean. In the case of a random walk with drift, pt = + pt-1 + t, so that rt = (pt - pt-1) = + t .(b) 17

CBO Occasional Paper No. 2006-2

As per this random walk process, thus, returns (rt) vary around an equilibrium return (), and the equilibrium return may be decided by standard asset valuation theories like the CAPM (Capital Asset Pricing Model) or the APT (Arbitrage Pricing Theory). Instead of return (rt), if risk-adjusted returns are used (i.e. rt ), then the random walk process also represents a martingale. In other words, if = 0, then the random walk process is the same as a martingale. (Thus, every random walk process is not a martingale, and similarly, every martingale process is not a random walk.) The efficient market hypothesis, in turn, can be presented as: rt = (pt - pt-1) = Et-1 (rt )+ t .(c) This suggests that the true returns vary around the expected return Et-1 (rt) (as against around t in case of a martingale process, and around in a random walk process). In most empirical tests of efficient market hypothesis, it is assumed that Et-1 (rt ) = (implying estimation of a random walk process). Since is derived through some asset pricing model (say like CAPM or APT), empirical test of EMH is always a joint test; first, the efficiency of the market, and second, appropriateness of the models in generating equilibrium (or fair level of) returns represented by . A rejection of EMH alone, therefore, may not indicate inefficiency, because it is possible that the markets may be efficient but the models used for generating the equilibrium returns may be wrong. Often, the EMH is difficult to study empirically because of the equilibrium rate of return concept around which the return in any single year is expected to hover around, and the scope for mis-measurement of the equilibrium return through a model (be it CAPM or APT). A more convenient, though still meaningful, option to empirically assess the EMH is through a random walk of the form rt = 0 + (i) rt-i + t .(d)
i=1 k

where i = 0, for i =1.k, which suggests that todays expected returns are not determined by past returns (i.e. information on past returns are not relevant for arriving at future expected returns). The EMH also assumes homoscedasticity (i.e. time invariant variance of the error term), which may not often hold due to the generally observed presence of heteroscedasticity (or time variant variance) in financial market data. A rejection of EMH as specified in equation (d), therefore, is not a rejection of weak form efficient market conditions, particularly in the presence of heteroscedasticity. High frequency market data (like stock prices and stock returns) often exhibit time dependent conditional variance, which can be studied through Autoregressive Conditional Heteroscedasiticy (ARCH) of Engle (1982) and Generalized Autoregressive Conditional Heteroscedasiticy (GARCH) of Bollerslev (1986). In the presence of time dependent conditional variance, correct specification of the conditional mean and conditional variance equations become crucial. The mean equation could generally look like: 18

CBO Occasional Paper No. 2006-2

rt = 0 + (i) rt-i + ht + t .(e) where (ht) is the conditional variance in the mean return equation, and the variance equation may look like: ht = 0 + 1 (t-12 ) . q (t-q2 ) + 1(ht-1 ) ..p(ht-p) ..(f) Appropriate specification of the conditional variance equation depends on proper choice of p and q (i.e. lags in the conditional variance equation) of the underlying GARCH (p,q) process. In equation (f), 0>0, i >= 0 and j >= 0 represent sufficient condition for ht to be positive in the mean return equation (e). It is necessary, however, that the specification of the conditional mean equation is appropriate. Misspecification in the linear mean equation could arise from omitted shifts in trends, incorrect choice of lag lengths in the autoregression process, presence of parameter instability, residual autocorrelation, as well as omitted variables from the mean equation. Incorrectly specified conditional mean equations could give rise to incorrectly specified conditional variance equation. In such cases, rejections of EMH may actually represent errors in specification of the test rather than the efficient market condition itself. The conditional mean equation (e) suggests that stock returns could increase if conditional variance ht increases. If (ht) can be predicted from historical data on stock returns, then that could tantamount to rejection of EMH. For the empirical assessment of the EMH in respect of MSM based on the approach outlined above, data on daily MSM 30 index (scaled uniformly to scale 1000) for the period February 1997 to July 2006 have been used (Chart 7). This period includes the phase of the market crash of 1998 as well as the strong rally seen during 2005, and such wide swings are difficult to explain in any empirical analyses in terms of pure fundamentals. The weak form of the EMH only can indicate whether based on information embodied in the past behaviour of the MSM data series, the behaviour of the series could have been predicated to some extent for profitable use in any investment strategy. As could be seen from Table-3, Augmented Dickey-Fuller (ADF) and PhilipsPerron (PP) tests of stationarity suggest that while (log) of the MSM price series is I(1), the daily return series on MSM is I(0). As could be seen from

As per standard empirical finance, higher return could be a compensation for bearing higher risk, and hence, return data must exhibit increasing trend in relation to risk represented by variance (irrespective of whether unconditional variance or conditional variance is used in the analysis). As per French et al , however, empirically stock returns may fail to exhibit statistically positive co-movement with unconditional variance, but returns generally tend to increase in relation to conditional variance captured through ARCH and GARCH specifications. Unlike Markowitz type analyses where risk of a portfolio is captured by variance-covariance, as per CAPM the risk of a stock can be captured correctly only through CAPM beta, even though multifactor models also can explain the return behaviour (and predict return to some extent as well) on the basis of behaviour of factors such as P/E ratio, market to book ratio, small firm versus large firm, etc. Other market anomalies like month of the year, day of the month/week, etc. as well as event studies (to capture the price behaviour before and after the announcement of any relevant information) and runs test (which is the non-parametric version of the serial correlation test) have also been studied in empirical finance to question the relevance of EMH.

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Chart-8, the distribution of daily (annualised) returns on MSM (February 1997 to June 2006) is symmetric. But the Skewness, Kurtosis and Jarque-Bera test statistics reject the null of normality, indicating the presence of fatter tails. Chart-9 also shows the presence of volatility clustering. The distribution characteristics of MSM stock returns are, therefore, typical of most emerging market economies. The autocorrelation functions of the daily return series presented in Chart-10 also suggest that the null hypothesis of noautocorrelation is rejected by the Ljung Box Q statistics for each of the 12 lags (in a stationary return data series, presence of autocorrelations could be an indication against EMH, but the extent of autocorrelation may not be enough to emerge as a source of excess profits, particularly if the transaction costs are high in a market. The autocorrelation coefficients have to be large enough to be a source for generating excess returns.)

Table-3; Tests of Stationarity Log (MSM) Return (rt) ADF -0.550743 -10.95505 SIC lag-14 SIC-lag13 PP -0.477474 -44.75293 Newey West Newey West bandwidth 20 bandwidth 18 Based on optimal lag/bandwidth, both ADF and PP test statistics suggest that Return (rt) series is stationary.

Chart-7
6000

5000

4000

3000

2000

1000

Daily MSM General Index (Feb. 1997 to July 2006)

r Daily return is calculated as (log Pt ) (log P t-1 ). This is so because, Pt = P t-1 * e r In other words, Pt / P t-1 = e . Taking log on both sides, we get (log Pt ) (log P t-1 ) = r.

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Chart-8
1000
n r u t e R e m a S h t i W s y a D f o r e b m u N Series: DAILY RETURN Sample Feb.1997- July2006 Observations 2347 Mean Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 0.000328 0.152225 -0.128705 0.010466 0.863051 45.79506 179388.7 0.000000

800

600

400

200

0
-0.10
-0.05
-0.00
0.05
0.10
0.15
Distribution of Daily Return on MSM General Index

Chart-9
.20
.15

n r u t e R f o e t a R y l i a D

.10
.05
.00
-.05
-.10
-.15

Daily Return Data Showing Volatility Clustering

February 1997 to July 2006

Chart-10 Autocorrelation Functions of Daily MSM Return Series

Autocorrelation |* | | |* | | | | | | | |* | | | | | | | | | | | | Partial Correlation |* | | | | | | | | | | |* | | | | | | | | | | | | Lags 1 2 3 4 5 6 7 8 9 10 11 12 AC 0.117 0.058 0.058 0.071 0.017 0.019 0.036 0.032 0.038 0.025 0.048 0.095 PAC 0.117 0.045 0.047 0.057 -0.002 0.009 0.027 0.020 0.029 0.012 0.036 0.080 Q-Stat 32.295 40.324 48.193 59.934 60.642 61.509 64.575 66.945 70.434 71.899 77.249 98.540 Prob 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000 0.000

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Empirical estimation of equation (d) [ i.e. rt = 0 + (i) rt-i + t ] for testing the EMH suggests that there could be many specifications for MSM return data as reported in Table-2 for which ( i) are non-zero, and statistically significant. The first two equations in Table-4 indicate that daily MSM return series at time (t) exhibits statistically significant relationship with lagged returns (for lags 1,2,3,4 12 and 13). Under conditions of EMH, the estimated (i) coefficients should have been either zero, or statistically insignificant. Table-4 estimated serial correlation coefficients in return data is suggestive of rejection of EMH. Since the drift parameter in the first two equations are statistically insignificant (whereas as per equation-b type specifications the drift parameter should be positive and significant, since our return data are not adjusted for risk free rate of interest), in the last two equations in Table-4 the constant has been dropped and the equations have been re-estimated. The estimated coefficients, however, continue to reject EMH. Such rejection could be on account of incorrect specification of the mean equations, particularly in the presence of time varying conditional variance of the error term. As per ARCH-LM test of the errors of all specifications presented in Table-4, there is clear evidence of heteroscedasticity in the return data, and hence, the return equations have been estimated in ARCH and GARCH specifications (Table5). Table-4: Linear Random Walk Equations of the MSM Return rt = 0.0002 + 0.11( rt-1) + 0.04( rt-2) +0.04 ( rt-3) +0.06( rt-4) (1.12) (5.18)* (1.81)*** (1.96)** (2.79)* rt = 0.0002 + 0.11( rt-1) + 0.04( rt-2) +0.04 ( rt-3) +0.06( rt-4) + (1.04) (5.41)* (1.94)*** (1.87)*** (2.90)* +0.10( rt-12) - 0.13( rt-13) (4.94)* (-6.23)* rt = 0.11( rt-1) + 0.04( rt-2) +0.04 ( rt-3) +0.06( rt-4) (5.21)* (1.84)*** (1.99)** (2.81)* rt = 0.11( rt-1) + 0.04( rt-2) +0.04 ( rt-3) +0.06( rt-4) + (5.44)* (1.96)** (1.89)*** (2.92)* +0.10( rt-12) - 0.13( rt-13) (4.97)* (-6.26)*
*, **, *** represent statistical significance at 1%, 5% and 10 % levels, respectively.

As we know, corrections for heteroscedastic errors could improve the efficiency of the estimated parameters. When variance of the error term varies directly with one or more independent variables in the regression equation, use of weighted least squares technique could transform errors into a homoscedastic process, and thereby OLS could still throw efficient parameter estimates. One could also use White's correction for heteroscedasticity. In turn, however, when the error term is not a function of one or more independent variables in the regression equation, but instead varies over time in a manner so that large errors are followed by large errors and small errors 22

CBO Occasional Paper No. 2006-2

are followed by small errors (i.e. current errors depend on how large or small were the past errors), it becomes useful to apply ARCH and GARCH techniques. As per the estimated equations presented in Table-5, the coefficients of the ARCH and GARCH parameters in the mean equations as well as all coefficients of the variance equations are statistically significant. The sum of the ARCH and GARCH coefficients is not greater than 1, signifying the volatility process to be stationary. Moreover, the sum of ARCH and GARCH coefficients are almost equal to 1, indicating that volatility shocks are quite persistent. The efficient market hypothesis, as we know, assumes homoscedatstic errors in the random walk specifications of returns, whereas errors, as we see in the case of MSM return data, could be heteroscedastic, which in itself could be a factor contributing to the rejection of EMH. In respect of MSM data, thus, the standard tests of EMH indicate that not only MSM returns are highly correlated, but they also exhibit the presence of conditional variance. There could, thus, be scope for use of serial correlation coefficients and the predictable conditional variances for generating excess returns, implying rejection of the weak form efficient market hypothesis for the MSM.

Table-5: ARCH and GARCH Mean and Variance Equations The GARCH in Mean Equation rt = 0.07( rt-2) +0.07 ( rt-3) +0.04( rt-4)+ 4.85 (ht) (3.20)* (3.07)* (1.86)*** (2.79)* The GARCH(1,1) Conditional Variance Equation ht = -0.0003 + 0.25(t-12 ) + 0.75(ht-1 ) (14.41)* (18.51)* (83.9)* The ARCH(M=3) Mean Equation rt = -0.0009 + 0.39( rt-1)- 0.07( rt-2) +0.09 ( rt-3) (-2.87)* (17.18)* (-3.86)* (4.15)* +0.09( rt-4)+ 0.18 (ht) (6.55)* (3.90)* The ARCH (M=3) Conditional Variance Equation ht = -0.0002 + 0.53(t-12 ) + 0.35(t-22 ) + 0.13(t-32 ) (24.47)* (20.05)* (14.10)* (5.85)*
*, **, *** represent statistical significance at 1%, 5% and 10 % levels, respectively. As per the ARCH-LM test statistics, the errors in both mean equations turn out to be homoscedastic (i.e. with no further time varying variance). While the first mean equation has variance (ht), the second mean equation has standard deviation, i.e. (ht)
.

Section-IV: Concluding Observations Excess volatility in stock prices in relation to the volatility in the underlying fundamentals has been a common feature of most of the stock markets, and the search for fair value of a stock has almost always been illusory, leading to sustained interest of the practitioners in the empirical debate on the efficiency of the markets. Believers in the efficient market hypothesis may argue that stock picking on the basis of identification of overvaluation or undervaluation 23

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of a stock cannot fetch higher return on a consistent basis, unless such strategies also mean corresponding higher exposure to risks. There have been empirical evidences to suggest, however, that excess returns can be made without exposure to higher risk, and such excess returns could accrue to both uninformed investors as a matter of pure chance and to the informed investors as a compensation for the cost they incur in acquiring and processing information. As per the well known Grossman Stiglitz paradox, if all information were reflected in market prices, then there wont be any incentive for anybody to acquire and process information, and hence, the information could never get reflected in the market prices. In this debate, the reality may lie somewhere in between, so that stock price movements could be viewed to have both a rational component as well as an irrational fads and fashion component. While rational informed investors may trade (or even speculate) on the basis of information, noise traders may trade and speculate on the basis of incomplete or no information. It is the informed rational investors who add efficiency to the market, though gradually, and during this process noise traders may also help the market by adding depth and liquidity. Despite the informed investment decisions of rational investors, and their growing importance in a market, there will always be some anomalies in the market, caused by the actions of noise traders and uninformed fads and fashion driven speculation, which some investors can exploit to reap higher return. Every time such anomalies are detected, however, due to competitive search for excess returns, better information gets priced in the market. As rightly noted by Campbell, Lo and MacKinlay (1997), recent econometric advances and empirical evidence seem to suggest that financial asset returns are predictable to some degree. Thirty years ago this would have been tantamount to an outright rejection of market efficiency. However, modern financial economics teaches us that other, perfectly rational, factors may account for such predictability. The empirical assessment of the MSM general index suggests that it has been much more volatile in relation to the more stable underlying fundamentals, and individual firm level performance in terms of price-to-earnings ratio, dividend yield, price-to-book ratio, dividend payout ratio, etc. has been quite divergent. Based on firm specific anomalies in relation to individual specific perceptions about undervaluation or overvaluation, there could be potential for excess return, even though it is difficult to establish as to whether such potential for excess return results from associated exposure to higher risk. When one looks at the recent strong rally in the MSM till mid- 2005 and the subsequent correction and recovery, one could infer that higher return stemming from the rally could be temporary and must be associated with higher risk. Without any information on individual investor specific performance, it is difficult to infer as to whether anyone could consistently beat the market in both phases of strong rally and subsequent correction. Most importantly, it is even more difficult to establish whether any investor could predict both the rally and the subsequent correction, and as a result could make excess returns during both phases of the market in relation to the average expected market performance. Unlike micro level firm specific or investor specific assessment, a broad assessment at the macro level based on the MSM general index suggests that analysis of information contained in the past data can make the return as well as volatility of return somewhat predictable. While the random walk type tests suggest presence of correlation in returns, ARCH 24

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and GRACH specifications of the testable equations indicate that the variance of MSM returns are time variant, and conditional variance can be predicated as well. Even though tests based on random walk and ARCH/GARCH could suggest rejection of the weak form efficient market hypothesis for the MSM, in view of the age old challenge of correctly estimating the expected return, it is extremely difficult to establish whether predictable information identified from the past data can be used to generate excess returns in relation to expected return in Oman. Expected returns based on both CAPM beta (i.e. higher the risk explained by stock specific beta, higher must be the expected return), and multifactor models (i.e. expected higher returns associated with stocks having low P/E, low price-to-book value, and small size of a firm, etc.) may be widely recognized by the investors in general in the market, leaving little scope for any extra information that could be used by any investor to reap additional return in excess of the expected return. In the absence of correct estimation of expected returns in relation to risk, empirical assessment of efficient market hypothesis can potentially yield erroneous conclusions. In Oman, it may be necessary that investment decisions in the MSM are increasingly made on the basis of quality equity research, so that investors become aware beforehand about the higher risk associated with higher expected returns from a stock, and the chance factor associated with any excess return that may occasionally arise in relation to expected return. Greater informational efficiency can bring greater clarity to the expected empirical relationship between return and risk, and till greater informational efficiency is attained, the return on equity research may consistently exceed the normal risk-specific expected return of a stock. This is evident from the return track record of certain investment firms/funds even in advanced and more efficient markets. In the absence of adequate equity research, pricing of stocks in the market may continue to be dominated by investors search for quick and high returns, quite unrelated to the underlying information and risk. In such a market, instead of long-term investors, it is the investors with short investment horizon only will dominate, who will buy a stock with the clear intention to sell sooner at a higher price. Thus, there will be a continuous search for a bigger fool, and the price formation process in the market would get continuously distorted devoid of any regard for underlying information or risk. Mis-pricing of stocks would also entail the macroeconomic cost in terms of inadequate mobilization of savings for long term investment as well as inefficient allocation of saving among competing investment needs. It is important to note, however, is that no single empirical paper like this one can yield any conclusive evidence on the validity of the EMH for the MSM, even though more of similar research undertaken by market participants to back their investment decisions can help over time, not only in gradual empirical validation of the EMH but also in enhancing the efficiency of the MSM through better pricing of information in the market.

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