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Last Friday I posted a little statistics quiz. The claim was made that foreign investors are not responsible for the rise in India’s stock prices because foreign investors make up only 25% of the trading volume and that amount hasn’t changed substantially.

A reader correctly pointed out that if you remove 25% of the trading volume then you may have removed most of the catalyst for the increase. However, the specific statistical error made here is that the claim assumes that 25% represents the same amount of volume now as 25% of the total volume has in the past.

For hypothetical illustration purposes, lets take a single stock with a fixed number of shares. Let’s say there are 1 million shares available and that there are foreign buyers and Indian buyers and that the foreign buyers make up 25% of the total buyers and Indians 75%. Now lets say that the total number of people that want to own this stock is 1,000 and each person is wants to own 1,000 shares at a given price. So there are 250 foreigners and 750 Indians.

Then interest in this stock increases and now there are 2,000 people who want to buy the stock. Hypothetically, lets say that interest in the stock increases proportionally. Now there are 500 foreigners and 1,500 Indians who want to own the stock. Since the number of shares is fixed in my example 2,000 people can’t own 1,000 shares each since there aren’t 2 million shares available to meet the demand at the current price.

In the real world the price increases until some buyers drop out, and some want to own fewer shares. A new equilibrium price is reached where there might very well be more buyers each owning fewer shares on average. Consider Berkshire Hathaway (BRKA) stock. At $95,800 per share investors on average will obviously be holding far less shares than they would of say IBM (NYSE:IBM) at $79 a share. Indeed, many investors can’t afford to own a single share of Berkshire Hathaway.

So, it might be true that that foreign investors aren’t responsible for the increase India’s stock prices, but the claim that only 25% of the volume is attributable to foreigners doesn’t prove it, because if total volume increases faster than the number of shares, the ratio of foreigners to Indian investor as a percentage of total volume could remain the same, but prices would be pushed higher. If you take away the foreign investors, as the reader said, the ratio of foreign investors would go down, and the price would not go as high.

That raises the following question: does the tail wag the dog? Did foreigners get interested in Indian stocks because Indians were increasingly interested in their stocks, or did Indians become more interested in their stock market because of the increase in foreign investment interest?

My claim that it was foreign investment that is responsible for the increase in Indian stock market prices is not at all an Americentric viewpoint. I look back to our own stock market bubble in the late 90s, which I attribute almost entirely to the advent of online trading. This, I think, resulted in a massive increase in interest among retail investors in the markets. Those retail investors included both Americans and foreigners. America was the first to go gangbusters in online trading, so with few exceptions, if foreigners wanted to trade stocks online they traded American stocks.

If you took away all of the increase in volume attributable to foreign stock buyers trading online, I posit that quite a bit, but not all, of the catalyst for the increase would have been removed. Much of the buying in a bubble, like the BSE is in right now, comes from momentum buying and following. What makes a bubble get to where it does is a multiplicative increase in prices to the point of saturation that comes from a multiplicative increase in buyers. Momentum starts to increase and the increase in momentum attracts more buyers, which make the momentum increase even more, until you get to the point where everyone who ever wanted to buy stocks has already bought them and can’t buy any more.

So that’s what I’m saying has happened in India. When the U.S. stock market was sucking eggs, Wall Street, which works hard to sell us whatever we are most willing to buy, pimped the foreign investments heavily. I remember a couple of years ago when it seemed like all you’d hear on CNBC all day long was China this and India that. They got the momentum started.

Fundamental analysts are always able to fundamentally justify any price for any stock that they so choose because the rules and measurements are mostly arbitrary, pseudoscientific, and open-ended. You can never prove or disprove the growth assumption that’s used in calculating a current value nor how far out someone should be willing to pay in advance for growth. You can adjust either one of those factors, the amount of expected future growth or the how far in advance you are willing to pay for it, and it changes the price you are willing to pay, drastically!

Source: Who's Responsible for the Indian Stock Bubble?