Why the ASX could be in for a rough ride

If I wrote a book about predictions, it'd have two, very short, chapters.

a woman

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If I wrote a book about predictions, it'd have two, very short, chapters. The first would be entitled "Don't do it, if you want a reputation for accuracy". The second, owing to the short attention spans of most people who pay heed to such predictions would be entitled "But do it anyway: they'll forget your mistakes and if you get lucky, you'll have a long career as an after-dinner speaker".

I wish that was satire. The book won't get written, but the principles are sound. How often have you checked to see whether each pundit was correct with each call they made? And how often does the someone win the prediction lottery and get feted for years?

And so, it's with trepidation that I venture into this space: I value my reputation more than I seek notoriety (but after-dinner speaking engagements are welcome).

Because of such concerns, I'm going to avoid the big calls. No, the market isn't going to fall 80% (despite some claims). Nor is the Dow going to 40,000 any time soon, despite the predictions of the 1999 book, which predicted it would happen well before now.

Instead, I want to share some thoughts based on a couple of data points. And the result is that, on balance, I think we're in for less rosy next half-decade than we're used to. Importantly, I want to make the case for investing anyway.

Four reasons for doubt…

Here's the first data point: The price-to-earnings ratio of the ASX 200, according to S&P CapitalIQ, is almost bang on 19 times earnings. That's a decent bit higher than the approximately 15 times that the index has averaged in the past.

Next, interest rates are, in all likelihood, going to be higher rather than lower in future. Higher rates should, the theorists tell us, cause asset prices to be lower, rather than higher (because the money to buy those assets is, in short, more expensive).

Third, the composition of our index doesn't exactly favour growth: we have a dearth of large, high-growth companies in general, and fast growing technology companies in particular, that could otherwise justify the aforementioned high P/E.

And lastly — I think, most importantly — the composition of our market may well work against us in a far more challenging way. Our financial services sector makes up over 40% of the ASX 200 index. The same financial services sector facing almost-daily shellacking at the Royal Commission, the one cutting fees, the one selling off the wealth management crown jewels, and the one facing flat or declining house prices (and hence falling loan values). Another 15% or so is in mining… with high copper, oil, iron ore and coal prices. Which, cyclically, are likely closer to the top than the bottom when it comes to commodities.

So, let's say around 60% of the ASX is either sailing into headwinds or, more charitably, with little to no tailwind. And if there is little to no growth to be had, profits and share prices will similarly struggle.

And let's do the maths. If three-fifths of the market might struggle to grow, how much heavy lifting does the rest of the market need to do? A lot, I'd say.

On balance, if I'm right, a sluggish finance and mining sector is bad news for investors who are looking for growth. That's if you own those companies. Or if you own the market as a whole, via a market-wide exchange-traded fund.

… and one to believe

A prediction? Not so fast. It's possible that housing resumes its upwards trajectory. It's possible our banks find a new way to grow. And commodity prices could rise further, before they fall. I'm not silly enough to pretend I know for sure. Instead, let's look at the probabilities. Do you really think those sectors are likely to grow meaningfully over the medium-term from here?

And if they're not? It's no bad thing, as long as you're not tied to the performance of those sectors. On the contrary, the middling performance of such companies will likely mask the success of smaller ones which, while not having much impact on the market as a whole, still provide meaningful opportunities.

When we think about shares, we're trained to look at the market indices — the ASX 200 or the All Ordinaries. And that's for good reason: they are the sum total of the performance of all of the companies that are listed on our exchange.

But that doesn't mean you should invest accordingly. I think the ASX, as measured by those indices, might be in for a tough ride. The enterprising investor, though, who carefully selects companies to invest in, stands to do better than the index, and perhaps meaningfully so.

So, here's to the smaller, growing companies that could power, if not the ASX, then our portfolios. The ones that are lesser known today, but the household names of tomorrow.

Here's to the next generation of winners.

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