For the past ten days the financial world has been in a state of turmoil, inspiring lurid headlines about a global financial “meltdown”. What has been going on in financial markets? And what does all this chaos mean for the “real” economy of jobs, high street sales and houses? Both of these questions can be simply answered.

What’s happening in financial markets is that prices are going up and down. What all this means for the real economy is precisely nothing. I’m sorry for this bathetic introduction, which would doubtless have earned me a failing grade in journalism school. So let me hasten to add that, starting with the blindingly obvious fact that markets move up and down, we can move a step further and consider why.

The market in any share or currency or other asset always represents a balance between thousands of intelligent buyers, who think the asset is a bargain, and thousand of equally knowledgeable sellers, who think it is too dear. This means that there are always convincing arguments for the price to move higher and equally plausible reasons to believe that it should fall. With the arguments for higher and lower prices always so finely balanced, a very small shock or change in expectations can often be sufficient to trigger a big market move.

This was what happened ten days ago, when the Shanghai stock market fell suddenly in response to rumours of a new tax. The idea, widely reported in the media, that the plunge in Chinese share prices was somehow connected with the danger of a US recession was pure hokum, as was the even more outlandish claim that the ricochet effect of falling prices from Shanghai to Tokyo, London and Wall Street somehow reflected a shift in the global balance of financial power.

What then did cause global share prices to plunge? There are, in principle, three forces that can shift the balance between buyers and sellers. These are: outlook for economic growth and corporate profits; the level of interest rates; and the “valuation” of share prices themselves — essentially whether shares are perceived as cheap or expensive.

The first of these factors, the interdependence of the stock market with economic growth, gets most media attention, but it is actually the least important. The stock market has always been a poor forecaster of economic conditions, as summed up in the 1960s adage that “Wall Street has predicted six of the last three recessions”. In the past few years, the link between stock markets and economic performance has, if anything, got even weaker — as evidenced by the lack of response in the world economy to the stock market crash of 1987, the Russian default of 1998 or the bursting of the dot-com bubble in 2000.

A key reason for this decoupling has been the realisation that interest rates have a much greater influence on share prices than do rates of economic growth. Since central bankers have tended to reduce interest rates whenever share prices have suffered sharp corrections, this has introduced a self-stabilising element into stock markets. A big risk for investors is that, at some point, central bankers will stop this stabilising behaviour if they see inflation accelerating and feel obliged to raise interest rates, even as share prices fall. This is why inflation and economic overheating are far greater dangers to stock market investors than signs of an economic slowdown. For the moment, however, inflationary pressures seem to be abating, implying that a serious bear market is much more likely towards the end of the decade than in the year ahead.

If changes in interest rates and growth expectations have not been sufficient to explain the sudden shift from buyers and sellers, this leaves the third factor — market prices themselves. In the past eight months, share prices have risen almost continuously, to the point where many investors consider them ridiculously expensive, even assuming that global growth continues and interest rates remain where they are. Other investors, by contrast, are convinced that shares are still quite cheap, and this bullish group was until recently in the ascendant.

Thus the key disagreements among investors today are not over whether the world economy will sink into recession or whether interest rates will go up or down, but whether share prices at their present level are expensive or cheap. Some experts, mostly academic economists, argue that shares today are more expensive, in relation to long-term averages, than they have been since the dot-com crash. Others, for example private equity investors, cite different figures, suggesting that shares are cheaper than at any time since 1995 — and will thus represent excellent investments. Such disagreements among supposed experts may seem ridiculous, but actually they represent exactly the balance between bullish and bearish arguments that is in the nature of financial markets. A random, unimportant event, such as the Chinese tax rumour, is often sufficient to upset this fine balance.

The interesting question is whether this balance of bulls and bears has been reversed permanently, or only upset for a while.

This question presents a dilemma for stock market investors and central bankers similar to the one faced for years by house buyers in Britain. Academic economists have consistently cautioned that house prices were far above their historic averages and that buying property in Britain was foolish. Property specialists have argued, by contrast, that the historic averages established in the 1970s and 1980s had no relevance to present economic conditions and that houses were an excellent investment, even at seemingly “inflated” prices. We all know which side has proved right so far.

I suspect that the stock market bulls will also turn out to be right — and for much the same reason. The world has changed dramatically since the early 1990s and many of the rules of thumb established in the previous two decades — whether between house prices and average earnings or between share prices, profits and GDP — are no longer useful. If you believe these changes to the world economy will last for many more years, if not decades, you should remain bullish; if you believe that the world will soon return to the inflationary conditions of the 1970s and 1980s, you should sell everything.

There are, however, no guarantees in the world of finance. Regardless of the manic-depressive swings from euphoria to panic in media headlines, the arguments of the bulls and bears are always finely balanced.

Investors must ultimately make their own judgments — and always be prepared to be proved wrong.

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