The depressing truth about making money in today’s markets

Want to make money in the markets? You could do it the hard way. Or you could find a market that's been warped by central banks' endless streams of cash.


Mario Draghi of the ECB: playing havoc with the markets' capital allocation mechanism

Investing is ultimately about making money.

You have some savings. You want them to grow more rapidly than they would in the bank. You're willing to take some risk.

In an ideal world, you lend those savings to someone else who needs the money right now, in exchange for a higher interest rate. Or you use those savings to buy an equity stake that will allow you to share in the profits of a productive asset.

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Entrepreneurs look for opportunities to make money by solving problems by fulfilling demands that aren't already being met. People with capital fund these entrepreneurs.

Ideas that succeed will make more money and draw more competition into the sector, keeping prices under control. Ideas that fail, don't it's either back to the drawing board, or on to something new.

It's a pretty successful way to direct limited resources to where they're most wanted or needed.

It's also a million miles away from the reality of today's markets

How to make money in today's markets

Want to make money in the markets? You could spend time poring over accounts to find companies that are unquestionably cheap. You could put some of your hard-earned capital at risk, backing promising business ideas.

Alternatively, you could just find a market that's having an infinite stream of cash funnelled at it from a central banker's proton pack, and plonk yourself directly in the middle of that stream of cash.

Which is the best example of efficient capital allocation? I suspect it's the first. But central banks have decided that the second is the best way to make the economy better.

That strikes me as odd. But then, I'm not a qualified economist.

Anyway, I just bring this up in the wake of the European Central Bank's (ECB) latest rate-setting meeting yesterday. The ECB kept everything on hold and boss Mario Draghi told everyone to chill out a bit about Brexit.

He remains determined to do "what it takes". Although the biggest question there might be is there anything else he can buy?

Look at what's happening with investment-grade corporate bonds in the eurozone. The Financial Times notes that in the past month alone, the average bond purchased by the central bank has risen in price by 1.9%.

These companies don't really need this money. Their borrowing costs were already cheap. It's similar to the way that the benefits of quantitative easing have been most beneficial to those who needed it least.

And meanwhile, it's playing havoc with the capital allocation mechanism. Bond investors are basically making their money by front-running the ECB a big, keen buyer, with infinite pockets, piling into the market.

As Chris Telfer of ECM Asset Management tells the FT: "Everything is trading like it's being bought [by the ECB] anyway. Fundamentals don't seem to matter; I don't know anyone who feels comfortable buying into this."

And yet, why wouldn't you? What else are you going to do?

I reckon that most central bankers actually understand this, by the way. I don't think they're thick or entirely bound by ideology (Ben Bernanke might be the latter, but he's not the only central banker in the world).

This is why the pressure is growing for governments to spend. Central banks are already pushing their remits merely by playing this massive game of pass the parcel where they pump money in at one end of the market and hope it somehow trickles down to the real economy via a wealth effect and a "swap this asset for a slightly riskier one" effect.

Only a government with a democratic mandate can take that money and funnel it in a specific direction.

Of course, then your process of efficient capital allocation is entirely out the window. But that's a problem for another day.

An encouraging deal in the mining sector

Anyway, moving onto something completely different, and with much more connection to the "real" world - we all know that mining is a cyclical business. As such, it's a sector where I struggle with the idea of a "buy and hold" strategy. If you want to make the outsize gains that are sometimes on offer in this sector, then you have to buy when stuff is cheap and unpopular, and sell when it's much-loved and expensive and annoyingly, no one rings a bell at the top or the bottom.

The good news is though, that there are a lot of old hands in the sector who seem to know what they're doing (it's not so different to the commercial property sector from that point of view). Paying attention to their actions can pay off.

Mining stocks in general (and gold specifically) have done well this year as hints of a recovery come through. Can it continue? Well, here's an interesting deal in the sector: Japanese mining equipment maker Komatsu is buying American peer Joy Global.

These stocks are the "picks and shovels" plays (quite literally) on a mining boom. It doesn't matter if anyone finds anything in the ground as long as they're in the business of digging, these companies will do well.

Komatsu is paying $28.30 a share. It's a 20% premium to the pre-bid price and it's certainly not cheap it's a big multiple of current earnings. But as Lex in the FT points out, Komatsu ruled out doing a similar deal in 2012. Back then, doing the deal at the same multiple would have cost $90 a share.

This is simply about "timing the cycle", notes Lex. And between them, the two companies are old enough to "have seen a fair few of those". The multiple might look expensive today, but not if earnings recover sharply.

To me this looks like a vote of confidence in the mining turnaround, rather than irrational exuberance. And while no sector is immune to the antics of central banks, miners at least produce assets that should benefit if all of this intervention eventually does produce inflation.

I'll be sticking with my mining stocks for now and I'd suggest you do the same.

John Stepek

John Stepek is a senior reporter at Bloomberg News and a former editor of MoneyWeek magazine. He graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.