The Arab Stock Market Crash

What started as a significant correction in Saudi stock values appears to be spreading to other Arab markets. Some of the gory details are contained in this report from Bloomberg. The Tadawul, the leading Saudi stock index, is down 28 percent since hitting an all-time high on Feb. 25. (This would be the equivalent of the Dow losing about 3080 points in the same period.) Less spectacular but still substantial declines are reported in Egypt, Kuwait and Dubai.

Given that price-to-earnings ratios had reached 40 for many Saudi stocks, this is not unexpected. (During the US NASDAQ boom, many P/E ratios were infinite for some years, in that many firms with rapidly increasing stock prices had never reported profits.) But this is not as helpful as it first seems: why should the ratios ever get to such stratospheric levels in the first place? (According to conventional wisdom, they historically average between 17 and 20.)

There are several things going on here. First, such events do not happen, contrary to conventional wisdom, because investors lose their minds -– either during the manic rise in prices nor the panicky selloff that follows. Theories that depict bubbles and crashes as irrational events always seem unpersuasive, in that they offer no reasons why investors would be sober-mindedly rational most of the time and then become unhinged only during bubble/crash episodes. Instead, during these times the market is doing what it always does -– assimilating each investor’s private information as revealed by his willingness to buy or sell at a given market price. The market-clearing price serves to assimilate all this information. This is known as the “efficient markets” hypothesis, and while it is far from a majority view among financial economists, it seems to me the only way to make systematic sense of investor behavior over time.

Rather, what drives these events must be some information setup that causes them to bid up the prices of a lot of assets across the board to very high levels before selling most of them. And this has to do with a particular combination of great potential (either because of a new technological development like information technology or because a developing country appears to be growing rapidly) and great uncertainty (in which the exact nature of how the new technology will eventually be used or what a country will eventually be good at remains to be learned). In such an environment, investors know that something truly groundbreaking is taking place, but the only way to be part of it is to buy some ticket, any ticket to this lottery. They thus collectively spread their bets across all assets while this uncertainty still exists. Eventually, a moment of clarification comes when some bets are now seen to be much better than others -– E-Bay, it turns out, is a great idea, dot-com high fashion with what consumers ultimately judge to be a terrible interface (Google boo.com to get some idea) is not.

So rationality holds out two possibilities for explaining the Arab crash, if we take for granted that much of what goes on economically in these countries is oil-driven. Some of these countries are awash in oil money because of surging prices in the last few years, and so either investors are betting that the oil windfall is over (although oil futures prices don’t suggest that as far as I know), or these countries have spent some of their money foolishly, and investors are suddenly passing a judgment on that. (Egypt, a non-exporter of oil, is admittedly harder to explain using this approach, although the economy is perhaps tremendously dependent on remittances from the Gulf states.)

But one canard about globalization-era financial crashes is clearly called into question: the idea that foreign investors, with their huge trading volumes and emotional overreactions, are to blame. This theory was trotted out to explain the East Asian crash of 1997 and others that followed. Economists such as Paul Krugman will still occasionally argue that developing countries opening up to these kinds of investors is a mistake, and will cite Malaysia, which is allegedly the fastest-growing economy since the crash in that part of the world despite bucking the consensus and keeping these global stock and bond traders at bay. As it happens, Malaysia is not the fastest-growing nation since 1997 among those that crashed back then (Thailand is), and in any event blaming the foreigner will not do here because at least some of these countries (certainly Saudi Arabia) substantially limit foreign participation. The Arab crash is not a foreign problem, but an Arab one. Whether it is a correction or a major rout is still an open question, but it calls even more into question the idea that a China turned bubble might escape because of their restrictions on incoming foreign portfolio investment and on taking Chinese yuan out of the country.