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Equity Markets: Should You Follow the Herd?

All investors, however large or small, should always remember the paradox of financial assets pricing, which is this: they don't follow orthodox supply and demand rules. Think of practically any other good or service (cars, fridges, TV sets, iPads, taxi rides, haircuts, oranges, one gets the picture…) and then consider whether the demand for such assets rises if the price rises. The answer is almost invariably no. Its stands to reason – price goes up, the demand tails off.

Financial assets act differently. With them, as prices rise so does demand. (We can also consider housing assets or real estate to be financial assets for these purposes). This in a nutshell is the principal reason why crashes are an inherent part of the free-market capitalist system: a never-ending upward trend in price is not sustainable and the crash, or "correction", occurs because some fundamental part of the equation, be it personal debt levels, inflation, unemployment, etc, disconnects and pricks the bubble. (Hence the term correction: the high prices no longer reflect "fair value" and so prices correct themselves to reflect this).

The headlines recently are all very pro-equity. January 2013 was the best month for the FTSE100 since 1989. It has risen just under 5 percent since the end of 2012 and is about 900 points, or 17 percent, higher than its low point in 2012. Yesterday it stood at 6282.76, which was 35.9 points higher than Monday, when it suffered its biggest one-day fall in three months! That blip was put down to "euro zone fears".

What was the rise in January put down to? "Euro zone optimism"?

(Read More: 'Easy Money' Will Help Stocks for Foreseeable Future: Roubini)

As we've discussed ad nauseam in this column, the euro's problems are deep-rooted and structural, and while Mario Draghi's promise to do whatever it takes to support it (very John F. Kennedy-like, that one…) is more than just a sticking plaster, it isn't an actual solution. It defies logic to be optimistic or pessimistic about the euro from month to month, when nothing fundamental changes in such a short time period.

Of course the engine room of world economic growth is the USA. There have been some encouraging statistics of late coming from there, whether in the field of unemployment or real estate, and its equity markets have been similarly bullish of late. But new job creation needs to run at something like 250,000 every month all this year for there to be a real significant impact on unemployment, and there is still plenty of surplus housing stock that is sitting on bank balance sheets. Is the optimism of the equity markets justified?

Probably in the medium term, yes. But that's actually irrelevant. Equity market valuation has very little to do with "fair value". The sentiment only needs to be faintly positive and start somewhere, and the orthodox supply-demand relationship goes out the window. Follow the herd.

It's probably just as well that all market participants in finance have such a short-term outlook, even if in theory many are long-dated investors. When one stops to consider on-going choke points like euro zone debt, persistent high unemployment, ageing populations and uncontrollable welfare expenditure (all issues that are less relevant to Asia-Pacific markets, where rising markets can at least point to fundamentals), it's a miracle anyone would want to invest in the EU economy at all…

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Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons Ltd 2012).