Equities or shares represent holdings of ownership of public limited companies. When shares are listed, this means they are available to be bought and sold on national exchanges such as the London Stock Exchange (LSE) and New York Stock Exchange, (NYSE) or sometimes on smaller exchanges such as the Alternative Investment Market (AIM) or industry-specific exchanges such as the Nasdaq Stock Exchange. It is these exchanges which create the forum usually known as the "equity markets".

The New York Stock Exchange is currently the world's largest exchange, followed by the Nasdaq, London Stock Exchange, Tokyo Stock Exchange and then Euronext.

Companies can seek to list their shares on one or more exchanges when seeking to raise investor capital to help expand and grow the business. The shares may initially be offered as part of an IPO or Initial Public Offering or otherwise by way of a private placement amongst institutions nominated by the advising broker. It may be difficult for retail investors to participate significantly in an IPO.

However, once the shares have been listed on the applicable exchange, a secondary market will then exist meaning investors can buy and sell the shares from each other via the exchange. Owners of the shares will then be registered with the relevant exchange and share certificates issued. Market forces are thus able to operate freely and the traded prices depend on the current demand for the shares and their availability or liquidity. If the share is much in demand the price will rise, whereas if the company falls out of favour there is likely to be a selling off, and the price will correspondingly fall.

There are two ways in which investors seek to profit from equity markets; from expected dividend income paid by the company to its shareholders, and from an anticipated capital gain in the rise of the purchase price of the shares. See "Trading Derivatives" for an explanation of which aspects of trading equity derivatives are different to trading shares and which are the same. Trading derivatives can overcome some of the restrictions otherwise faced when trading equities.

Factors affecting equity markets

There are numerous factors which might be expected to affect the movements of equity markets including company-specific factors, interest rate decisions, inflation figures and market sentiment. We will look at these in turn.

Company-specific factors

A company is measured by analysts using a number of key ratios, including ratios relating to company earnings, profits, assets and working capital. Analysts seek to predict what value a company is likely to deliver, either through a future dividend stream to its shareholders, a future capital gain on a rising share price, or both. Analysts will then make recommendations as to whether they think a particular company is a good buy, a hold or a sell. Given that institutional investors still hold by far the biggest proportion of investment in the equity markets and typically deal in large volumes of shares, analyst recommendations tend to have a large effect on the price of a company's share.

What is important therefore is the news coming out from a company in terms of earnings figures, which are normally reported quarterly by a large company, and figures forecasting future earnings and prospects. If the figures are worse than expected, or if the company issues a profit warning suggesting that figures are going to be worse than forecast, there can be quite significant falls in the price of the company. Conversely, if company figures are better than expected, or forecast to be better than expected imminently, the price of the share might be expected to rise.

Interest rates

Interest rates that apply to investors are set by governments in conjunction with national banks such as the UK Bank of England and the US Federal Reserve Bank.

There is always widespread speculation on an international basis as to what governments and national banks will choose to do with interest rates. Ultimately what governments and banks are seeking to do in the current economic climate is to control inflation, which is the situation of too much money chasing too few goods, and which causes prices to spiral upwards. On a very simplistic basis, if interest rates are raised, this is intended to control inflation by making the cost of borrowing money more expensive, and reduce the pools of money available for buying goods.

If interest rates are raised, the immediate effect this has is to make it more expensive for banks to borrow money from the Bank of England (in the UK) or the Federal Reserve Bank (in the US). The filter down effect of this is that banks increase the rates they charge to their own customers to borrow money.

This will then impact upon companies, who will not be able to obtain finance as cheaply, and who may therefore scale back on investments for future growth. Reduced investment and reduced forecast growth figures, coupled with a more expensive discount rate with which to discount back future profits, are likely to impact negatively on analysts' valuations, which is likely to result in a fall in the company's share price.

Raising interest rates also impacts on individuals through higher mortgage costs and higher interest on other types of borrowing such as credit cards, (although also through higher savings rates on money deposited), which overall reduces the money individuals have available to spend in the form of discretionary money. This reduced spending therefore has a knock-on effect on companies, hitting both their top-line (revenue) figures and also their bottom-line (profit) figures, since the costs of borrowing for the company also increase.

An increase in interest rates would therefore normally be expected to have a negative effect on company profits and earnings, making the companies less attractive to buy at a time when more attractive savings rates are also available for cash balances.

Inflation

Inflation is a rise in prices over a period of time and is measured through various indices depending on how specific the information is needed to be. These indices examine price movements over a year, examples being the Retail Prices Index (RPI) in the UK or Wholesale Price Index (WPI) in the US.

Equity markets would usually be expected to react when there is a significant change in inflation either way over a period of time.

As above, governments and national banks will usually raise interest rates at a time when they are concerned about rising inflation. The effect of this it to make savings rate and debt instruments such as Treasury bills more attractive through increasing rates of return, typically at lower risk than from equity investments. This would therefore normally be expected to result in some investment monies moving away from equities to debt instruments.

However, the impact on equities of inflation will vary depending on which sectors and industries the companies in question are operating in, and how much of an effect inflation is having in these specific areas. For example, a rise in wheat prices might be expected to have a negative effect on food companies using wheat as a key ingredient in their products. It might have less of an effect on jewelers selling engagement rings. However, there are complex inter-relationships between different products and inflation particularly on a persistent scale can have a far-reaching impact on a wide range of products.

When looking at investment into individual equities, what must also be considered is the company's ability to pass on an increase in its input prices to its customers. If a company is able to do this without suffering a great reduction in demand, therefore maintaining its profit margins, the share price is likely to be affected less than that of a company who is less able to pass on higher prices to its customers.

However, if inflation is persistently high, this is likely to lead to a more widespread effect across whole economies as interest rates are likely to rise and demand likely to fall, thus potentially hurting revenue growth.

Market sentiment

There are a number of reasons why share prices might rise and fall which are not necessarily dependent on the real economic factors of the market or the economy and which are based on changes in market sentiment.

Market sentiment is very often at least partly fuelled by the press (although may not always follow what the press forecasts; there can sometimes be the opposite effect). Company reports and analyses and analysis of the health of the economy generally can have an impact both on investor activities and also consumer spending. For example, it might be argued that the technology boom of the late 1990s (or dotcom bubble) was exacerbated by mass coverage by the press and exuberant tales of "dotcom millionaires" being created on a daily basis.

Further examples of how market sentiment influences markets are that share prices might be flat during the summer as a significant proportion of investors are away on holiday, or that share prices might rise after a national team has won a big international sporting event, through increased spending and "feel-good factor".

It is dangerous to try to predict market sentiment however. It does not run according to any pre-set rules or paradigms, and many a distinguished economist has mis-read market sentiment, or under-estimated its effect.