MACROECONOMIC DETERMINANTS OF THE STOCK MARKET MOVEMENTS: EMPIRICAL EVIDENCE FROM THE SAUDI STOCK MARKET By MOFLEH ALI MOFLEH ALSHOGEATHRI B.A., IMAM MUHAMMAD IBN SAUD ISLAMIC UNIVERSITY, 1988 M.S., KING SAUD UNIVERSITY, 1998 AN ABSTRACT OF A DISSERTATION Submitted in partial fulfillment of the requirements for the degree DOCTOR OF PHILOSOPHY DEPARTMENT OF ECONOMICS COLLEGE OF ART AND SCIENCES KANSAS STATE UNIVERSITY MANHATTAN, KANSAS 2011 Abstract This dissertation investigates the long run and short run relationships between Saudi stock market returns and eight macroeconomic variables. We investigate the ability of these variables to predict the level and volatility of Saudi stock market returns. A wide range of Vector autoregression (VAR) and generalized autoregressive conditional heteroskedasticity (GARCH) models estimated and interpreted. A Johansen-Juselius cointegration test indicates a positive long run relationship between the Saudi stock price index and the M2 money supply, bank credit, and the price of oil, and a negative long run relationship with the M1 money supply, the short term interest rate, inflation, and the U.S. stock market. An estimated vector error correction model (VECM) suggests significant unidirectional short run causal relationships between Saudi stock market returns and the money supply and inflation. The VECM also finds a significant long run causal relationship among the macroeconomic variables in the system. The estimated speed of adjustment indicates that the Saudi stock market converges to the equilibrium within half a year. Granger causality tests show no causal relationship between Saudi stock market returns and the exchange rate. Impulse response function analysis shows no significant relationship between Saudi stock market returns and the macroeconomic variables. Forecast error variance decompositions suggest that 89% of the variation in Saudi stock market returns is attributable to its own shock, which implies that Saudi stock market returns are largely independent of the macroeconomic variables in the system. Finally, a GARCH-X model indicates a significant relationship between volatility of Saudi stock returns and short run movements of macroeconomic variables. Implications of this study include the following. (i) Prediction of stock market returns becomes more difficult as the volatility of the macroeconomic variables increases in the short run. (ii) Investors should look at the systematic risks revealed by these macroeconomic variables when structuring their portfolios and diversification strategies. (iii) Policymakers should seek to minimize macroeconomic fluctuations considering the effect of macroeconomic variables changes on the stock market when formulating economic policy. MACROECONOMIC DETERMINANTS OF THE STOCK MARKET MOVEMENTS: EMPIRICAL EVIDENCE FROM THE SAUDI STOCK MARKET By MOFLEH ALI MOFLEH ALSHOGEATHRI B.A., IMAM MUHAMMAD IBN SAUD ISLAMIC UNIVERSITY, 1988 M.S., KING SAUD UNIVERSITY, 1998 A DISSERTATION Submitted in partial fulfillment of the requirements for the degree DOCTOR OF PHILOSOPHY DEPARTMENT OF ECONOMICS COLLEGE OF ART AND SCIENCES KANSAS STATE UNIVERSITY MANHATTAN, KANSAS 2011 Approved by: Major Professor Lance Bachmeier Copyright MOFLEH ALI MOFLEH ALSHOGEATHRI 2011 Abstract This dissertation investigates the long run and short run relationships between Saudi stock market returns and eight macroeconomic variables. We investigate the ability of these variables to predict the level and volatility of Saudi stock market returns. A wide range of Vector autoregression (VAR) and generalized autoregressive conditional heteroskedasticity (GARCH) models estimated and interpreted. A Johansen-Juselius cointegration test indicates a positive long run relationship between the Saudi stock price index and the M2 money supply, bank credit, and the price of oil, and a negative long run relationship with the M1 money supply, the short term interest rate, inflation, and the U.S. stock market. An estimated vector error correction model (VECM) suggests significant unidirectional short run causal relationships between Saudi stock market returns and the money supply and inflation. The VECM also finds a significant long run causal relationship among the macroeconomic variables in the system. The estimated speed of adjustment indicates that the Saudi stock market converges to the equilibrium within half a year. Granger causality tests show no causal relationship between Saudi stock market returns and the exchange rate. Impulse response function analysis shows no significant relationship between Saudi stock market returns and the macroeconomic variables. Forecast error variance decompositions suggest that 89% of the variation in Saudi stock market returns is attributable to its own shock, which implies that Saudi stock market returns are largely independent of the macroeconomic variables in the system. Finally, a GARCH-X model indicates a significant relationship between volatility of Saudi stock returns and short run movements of macroeconomic variables. Implications of this study include the following. (i) Prediction of stock market returns becomes more difficult as the volatility of the macroeconomic variables increases in the short run. (ii) Investors should look at the systematic risks revealed by these macroeconomic variables when structuring their portfolios and diversification strategies. (iii) Policymakers should seek to minimize macroeconomic fluctuations considering the effect of macroeconomic variables changes on the stock market when formulating economic policy. Table of Contents List of Figures ......................................................................................................................... xi List of Tables ........................................................................................................................ xiii Abbreviations ......................................................................................................................... xv Acknowledgements ............................................................................................................. xviii Dedication ............................................................................................................................. xxi Chapter 1 : Introduction ........................................................................................................... 1 1.1. Statement of the Problem and Research Questions ....................................... 5 1.2. Significance of the Research ......................................................................... 9 Chapter 2 : Saudi Stock Market Overview ............................................................................ 11 2.1: Historical Development of the Saudi Stock Market .................................... 11 2.1.1: Stage I: Initial Stage (1935-1982) ................................................... 12 2.1.2: Stage II: Established Stage (1983 –2002) ....................................... 13 2.1.3: Stage III: Modernized Stage (2003-Present) ................................... 17 2.2: Performance of the Saudi Stock Market ..................................................... 20 2.2.1: Market Activity of the Saudi Stock Market .................................... 21 2.2.2: Size and Liquidity of the Saudi Stock Market ................................ 29 2.3: Saudi Stock Market Rank in the Arab World ............................................. 33 2.4.: Summary and Remarks .............................................................................. 37 Chapter 3 : Literature Review ................................................................................................ 40 3.1: Introduction ................................................................................................. 40 3.2: Theoretical Background .............................................................................. 40 3.2.1: Theory of Efficient Market Hypothesis (EMH) .............................. 40 3.3.2: Arbitrage Price Theory (APT) ......................................................... 42 3.3: Related Empirical Studies ........................................................................... 44 3.3.1: Studies Related to Developed Economies ....................................... 46 3.3.2: Studies Related to Developing Economies ..................................... 60 3.3.3: Studies of Multiple Countries ......................................................... 66 3.4: Summary and Remarks ............................................................................... 72 Chapter 4 : Macroeconomic Variable Selection and Validation ........................................... 74 viii 4.1: Introduction ........................................................................................ 74 4.2: Tadawul All Shares Index (TASI) ..................................................... 75 4.3: Money Supply (M1 and M2) .............................................................. 76 4.4: Short Term Interest Rate (Isa3) .......................................................... 78 4.5: Inflation (CPI) .................................................................................... 79 4.6: Bank Credit (BC) ............................................................................... 81 4.7: World Oil Prices (BOP) ..................................................................... 83 4.8: Exchange Rate (Ex) ...........................................................................