The GCC stock markets are classified by the MSCI as frontier markets which aspire to be upgraded to emerging market status which includes markets in the Middle East like Egypt and Morocco. Dubai and Qatar have been striving in the last three years to be upgraded to this status. Qatar suffers from a stringent 25% limit on foreign ownership, while Dubai which allows foreign investment up to 49% but has not proven that its new payment vs. delivery system is working well for more than two companies listed on its stock exchange.

Thus, it is interesting to have a rigorous research study that examines herding in frontier stock markets such as the GCC markets since most of the studies on this subject are focused on developed stock markets and few emerging markets like China and Taiwan.

My co-authors, Riza Demirer from Southern Illinois University  - Edwardsville and Mehmet Balcilar from East Mediterranean University in Northern Cyprus and I have embarked on a research paper to examine herding in the GCC stocks for Abu Dhabi, Dubai, Kuwait, Qatar and Saudi Arabia. We are finding fascinating results about those markets. We find these markets working in three hidden volatility states: low, high and extreme or crash volatility regime. These states can only be discovered by econometric techniques which can classify the days of the sample period into groups or regimes to exhibit different degrees of volatility.

What makes this finding more interesting is that herding takes place in the crash or extreme regime (the third hidden) state for all those GCC countries, except for Qatar where herding occurs only under the low and high volatility regimes. These two regimes are less volatile and less dangerous than the crash regime. A possible reason for this exception for the Qatar stock market is perhaps due to active presence of a big participant in its stock market which is the Qatar Investment Authority (QIA), the emirate’s sovereign wealth fund (SWF). Qatar considers its stock market as a wealth distribution mechanism to trickle wealth from the government to its people. Thus, QIA is likely to invest in the stock market to reverse negative tendencies or extreme volatilities which may help stop herding in its track. Kuwait Investment Authority also invests in its domestic market. On the contrary, Abu Dhabi’s SWF ABDIA is not allowed to invest in the local market. Having said all that, it is still not very clear to us how the participation of the powerful SWFs in the non deep GCC market affects herding.

Additionally, our research on inter-GCC herding shows no spillovers or contagion but co-movements among the GCC markets, particularly during the crash or extreme volatility regime. Such result confirms the previous finding that herding is most pronounced during the crash regime, underscoring that herding during the crash is a true result and is not a statistical artifact.

These results do not qualify those markets to be a safe haven to each other when their stocks held in a diversified portfolio, particularly in times of extreme volatility. But they make them look like a dangerous place in those times because investors herd together under extreme volatility, or doing likewise, making things worse. They can be likened to a multi-car crash accident during high speed on a freeway.

Investors who seek portfolio diversification benefits cannot find them in those markets in risky times. To avoid an avalanche of market crashes, policy makers should develop safety nets and circuit breakers that can stop crashes in their tracks and should propose rules to prevent instability. Practices such as naked selling are deadly for these markets. Regulators should institutionalize hedging instruments to enhance hedging effectiveness to deal with market crashes. For investors, on way to insure against risk in the GCC markets is to diversify their GCC portfolios with safety stocks (e.g., high dividend stocks) from outside the GCC regions.

The authors wish to thank our colleague Aksel Kibar at the Abu Dhabi Investment Company for answering our questions during the preparation of the research paper on which this commentary is based.