What do foreign flows tell us about stock market movements in the presence of permanent and transitory shocks?

Abstract

PurposeThere is no research on understanding the difference in the nature of volatility and what it entails for the underlying relationship between foreign institutional investors (FII) flows and stock market movements. The purpose of this paper is to explore how permanent and transitory shocks dominate the common movement between FII flows and the stock market returns. As emerging markets are a major destination of international portfolio investments, the author uses India as a perfect case study to this end.Design/methodology/approachThe paper uses the permanent-transitory as well as a trend-cycle decomposition approach to gain further insights into the common movement between foreign institutional investors (FII) flows and the stock market.FindingsWhen the author identifies innovations based on their degree of persistence, transitory shocks dominate stock returns, whereas permanent shocks explain movements in foreign institutional investors (FII) flows. Also, stock returns have a larger cyclical component compared to cycles in foreign flows. The authors find the sharp downward (upward) movement in the stock market (FII flows) cycle in the initial period of the COIVD-19 pandemic was quickly reversed and currently, the stock market (FII flows) is historically above (below) the long-term trend, hinting at a correction in months ahead. The authors find strikingly similar stock market cycles during the global financial crisis and COVID-19 period.Research limitations/implicationsEvidence suggests the presence of long stock market cycles – substantial and persistent deviations of actual price from its fundamental (trend) value determined by the shared relationship with foreign flows. This refutes the efficient market hypothesis and makes a case favoring diversification gains from investing in India. Further, transitory shocks dominate the forecast error of stock market movements. Thus, the Indian market provides profit opportunities to foreign investors who use a momentum-based strategy. The author also finds support for the positive feedback trading strategy used by foreign investors.Practical implicationsThere is a need for policymakers to account for the foreign undercurrents while formulating economic policies, given the findings that it is the permanent shocks that mostly explain movements in foreign institutional flows. Further, the author finds only stock markets error-correct in response to any short-term shocks to the shared long-term relationship, highlighting the disruptive (though transitory) role of FII flows.Originality/valueUnlike existing studies, the author models the relationship between stock market returns and foreign institutional investors (FII) flows by distinguishing between the permanent and transitory movements in these two variables. Ignoring this distinction, as done in existing literature, can affect the soundness of the estimated parameter that captures the nexus between these two variables. In addition, while it may be common to find that stock market returns and FII flows move together, the paper further contributes by decomposing each variable into a trend and a cycle using this shared relationship. The paper also contributes to understanding the impact of COVID-19 on this relationship.