Trouble in the desert?

Don’t confuse sentiment extremities with a secular under-performance for the Gulf region.  Performance is cyclical and nothing performs better than the worst performer.
Objectively understanding an opinion is hard, having an opinion harder, and challenging an established opinion hardest. Ruchir Sharma, the head of emerging markets at Morgan Stanley Investment Management wrote ‘trouble in the desert’ for Newsweek. He made a case why the Gulf has yet to emerge. On one side, it’s no surprise that the region is under extreme scrutiny both internally and externally. But on the other side it seems extreme negative sentiment is gone further than reality. A lot of what Ruchir wrote seems harsh. I will try to justify my case.
He says” The balance sheets of many Gulf countries are out of date with financial numbers disclosed well after the standard reporting period and few checks on insider trading.” Ok these are gaps to be filled, but accounting scandal happened in India and America under all care. If we are comparing emerging markets or specially China with the Gulf, we should also compare aspects like internet freedom. What corporate governance levels are we speaking about in China?
The article mentioned that there was a major disconnect between economic and stock market performance. “Over the past five years, the GDP of the gulf region expanded at an annual pace of nearly 5 per cent, yet the Gulf stock markets fell 20%.” The disconnect Sharma illustrates was highlighted three decades back when generation of thinkers proved that markets were inefficient. So what’s new here that markets are more volatile than real earnings? Robert Shiller’s American Economic Review paper from 1981 is an example.
Sharma also compares a time frame when markets fell 20% in Gulf and gained 80% in emerging markets. On the face of it this might look like a general case of underperformance for the Gulf region. However, looking at ADI and SSEC pair performance suggests differently.
Based on the performance cycle paper published in the Kyoto Economic Research Journal by Ionut Nistor and me in Mar 2009, I grouped ADI (Abu Dhabi Index) and DFMGI  (Dubai Index) with BRIC countries and benchmarked it with Nikkei. Assuming we could do a long – short strategy between ADI and SSEC (Shanghai Composite), we obtained the following results. From 2 Jun 2008-22 Oct 2008 (Long ADI – Short Shanghai) delivered 104%. From 23 Oct 2008- 28 July 2009 (Short ADI – Long Shanghai) delivered 176%. From 30 July 2009 – 14 Oct 09 (Long ADI- Short Shanghai) delivered 15%. From 15 Oct 09- 17 Dec 09 (Short ADI – Long Shanghai) delivered 18%. From 18 Dec 09 – 26 Mar 2010 (Long ADI – Short Shanghai) performed 15%. Surprising isn’t it, while Gulf is being bashed, its leading index ADI is outperforming the Shanghai composite by almost 15%.  On average ADI –SSEC, long – short pairs delivered 145% annualized. This suggests performance was cyclical not secular in favor of SSEC or ADI. So the Gulf underperformance was a myth.
Ruchir also mentioned that Gulf exchanges list so few quality companies. Now the question one can ask, is this an opportunity or risk? Market capitalization to GDP ratio of average 70% globally in good times suggests that Gulf region is undercapitalized. Hence this becomes more of a new issues and listing opportunity into growth markets, a flip side of a weakness.
Mr. Sharma also suggested the home grown human capital and technology was needed to create a home grown manufacturing base. Gulf is not the first to import human capital. History is replete with cases like this. After the China glut and Asian leadership in high tech manufacturing, Gulf focus might need a new direction.  I agree with Ruchir on aspects of tourism and its limitation and need for a better education, which could build and strengthen strong structural base for the Gulf.
MENA is not isolated from the global equity. When global equities exhaust not only MENA but also Shanghai will fall. Relative performance is a quantifiable way to compare markets and regions complementing it with understanding of fundamental aspects. Global equities should head lower along with the Gulf and Shanghai. A 6-9 month correction is all that separates extreme negativity from a reemerging Gulf.
The Alpha MENA published this week carries numeric ranking, performance cycles and strategy updates with running signals. On the multi week basis Ruchir is correct that Shanghai might outperform the Gulf, but this is a part of the cyclical performance characteristic of markets. To take it to the extent of suggesting that “it may take some time before anyone mentions Dubai or any Gulf capital in the same phrase as Shanghai.” is more sentiment than valuation. Experts as a group do miserably wrong. It’s something an opinion leader has to live with. But like Robert Shiller says “opinion leaders should offer stabilizing opinions when major under pricing occurs.” Despite the rally from March 2009 lows Gulf is still living an ordeal after 90% drop in value and talking about troubles can cause more stress than solutions.