THERE are usually two reasons why equities go up in price. Either earnings are rising or there is an increase in the multiple of earnings, known as the PE ratio, that investors are prepared to pay.

The fluctuations of the past year consisted initially of a dramatic fall, followed by a rally driven by hopes of recovery.

As the fall played out, the PE ratio initially fell, due to investors attaching a higher risk label to equities, because the cloudiness of the economic outlook made the value of forecast earnings less reliable. So the falls were a result of both fundamental deterioration and a higher risk premium.

Since last March, this process has reversed itself. Lower earnings have been reported for many companies, but the market has risen, because investors have been willing to pay more for those earnings.

At its low points, the UK market was trading on a multiple of under eight times expected 2009 earnings. With market earnings now around a third lower than expected a year ago, the PE would have risen to around 12 times earnings, if the market had not moved.

The market has risen to a PE ration of about 15. This has allowed share prices to rise, despite the earnings drop. This has happened for three reasons.

First, the falls were largely factored into expectations. So, there was scope for relief when earnings were reported no worse than feared.

Secondly, initial signs of stabilising economic output, followed during the summer by indications that growth had resumed, allowed investors to focus on higher estimates for 2010 and beyond, rather than being preoccupied by the damage suffered in 2009.

The third factor relates more intangibly to market psychology. The seizure in credit markets last year led to a high premium being placed on certainty, with government bonds doing well, and equities, at the other end of the spectrum, doing badly.

As the authorities' policy measures began to show success in reactivating markets last spring, investors began to evaluate investments on their merits more than solely driven by risk aversion.

We would all walk more carefully through a room littered with mousetraps if we were barefoot and blindfolded, than if we could see. More likely, we would simply do nothing.

The risk premium investors attach to equities has fallen, but to say they are less cheap than six months ago is not the same as saying they are expensive. The US market may have recently experienced its fastest six-month rally since 1933, but this followed its worst six-month fall since 1932.

In most cases, equity markets may have scope to rise further, but are now dependent on seeing confirmation of the economic and profit growth that they now assume. Last spring, equity investment was mostly about valuation, with equities at very low valuations.

Now valuations are still supportive, but further progress depends on earnings growth. So, much will depend upon whether the higher earnings forecast for 2010 are delivered.

This makes investment a more selective process, but one that ought to be able to beat the low hurdle offered by the vestigial returns on cash and, after tax, on government bonds.