The stock market, as Keynes observed, is a bit like a beauty contest in which the secret of success is not to pick the most beautiful contestant, but to try to guess which contestant everyone else will think is the most beautiful.The managers of most actively-managed funds are engaged in this game, which is why their turnover levels are so high and average long-term results so indifferent. If the amount you can earn on your bank account rises from 2 per cent to 5 per cent a year, it should make you think harder about the wisdom of investing money in shares, which offer higher returns than cash (but at the price of higher risk).It makes little sense to put £5,000 into a long-term bond that yields 5 per cent if you can earn the same return risk-free by keeping it in the bank.Finally, behavioural habits, or herd instincts, are a big factor in how financial markets operate in the short term. Technology means that we can switch our money in minutes from one side of the world to another.We can do the same with investments: even life companies, the dinosaurs of the investment world, now offer clients the chance to switch holdings from, say, UK property into Japanese equities at the click of a mouse.What this means, of course, is that share prices are also influenced by the current attractiveness of competing assets Interest rates are a key factor in this. The new money that investors direct into stock markets can also potentially go into other types of financial asset. A hundred years ago, the main alternative was government bonds, but today the list of competing asset classes has proliferated hugely. It is not the same as the share’s intrinsic value, or the price that would prevail if everyone who owns it opted to buy or sell at the same time.A secondary factor is that share prices are not set in isolation. If you feel confident about your finances and the world outlook, you may be more prepared to take risks with your money.

You will find yourself, for example, investing in emerging markets rather than boring old blue-chips.When something happens that worries you, or if your circumstances change, it is natural that you will look to draw in your horns a bit. Magnify that reaction many millions of times and you have one of the dynamics that drives current prices in global stock markets.The price you see on the screen is the marginal price of a share, the one at which a few active buyers and sellers are willing to trade. If fundamentals were all that mattered, the stock market would not move in anything like the jagged, volatile fashion it does.In part, the volatility of share prices has something to do with investors’ attitudes to risk. The revival of flows into equity funds points to the same thing happening in the funds market.The catch, of course, is that this is just not the way markets work, at least short-term.

In the short term, the price of securities is driven primarily by liquidity and investor sentiment, not by so-called fundamentals.The fundamentals of earnings, cash flow and dividends can and do change in response to the economic cycle and competitive pressures, but they never change anything like as fast as the way investors in aggregate choose to value them. Earnings yields are some way above comparable bond yields.
The case seems so good that it has made the life of stockbrokers, whose primary job is to sell shares, all too easy. The world economy has been growing strongly, company profits are at high or even record levels in some cases, and share-price multiples are not high by historical standards. Now all it needs to do is tidy up Heathrow airport, which I flew into last week, and which seems more squalid and tatty than ever. It wouldn’t take much money and might make us all more inclined to believe in BAA management’s ability to look after the fine assets they are entrusted with.s.ogrady independent.co.uk. If the stock markets are due for a significant correction, which we will discover in the next few weeks (and seems probable to me), what does it tell us about the way that markets operate?

The paradox is that the case for being bullish remains, on the face of it, so strong.