Auto Pain Spreads as Lending, Spending Bubble Pops

Stop me if you’ve seen this movie before: Central bankers flood the economy with cheap, easy money. Things go well for a while in the sector that benefits from it. But eventually lenders go WAY overboard.

They slash lending standards and jack up loan volume in a frantic race to the bottom of the credit barrel. That creates a gigantic, artificial bubble in that sector – which inevitably bursts when the tide goes out.

It happened in the early 2000s in the housing and mortgage sector. Then about a decade later, it started happening again – this time in autos. And just like the housing bubble popped back then, the auto bubble is starting to do so now.

The evidence is all around us in headlines like these …

“Auto Sales Fall for Fourth Straight Month” – Bloomberg, May 2, 2017

“U.S. Car Sales Drop Faster than Expected” – Financial Times, May 2, 2017

“U.S. Auto Boom Seems to Be History, Just as Trump Counted on Jobs” – New York Times, May 2, 2017

“Banks Pull Back on Car Loans as Used-Auto Prices Plummet” – Wall Street Journal, May 3, 2017

“As Auto Sales Cool, There are Great Deals to be Had – and Worries of a Lending Bubble” – Los Angeles Times, April 21, 2017

I could go on, but you get the picture. It’s the same sorry process that played out in housing and mortgages. And just like with that crisis, we at Weiss Research and Weiss Ratings started warning about this one well in advance.

Here is one sample alert from as far back as 15 months ago. I followed it up with this analysis here, this one here, and this one here – not to mention this piece from a month ago on the investment implications for the stock, ETF, and mutual fund world.

So let’s look at the data and see what it’s signaling about the depth and breadth of this unfolding crisis …

1. In the month of April, auto sales dropped 4.4% from a year ago at Toyota Motor (TM, Rated “C”) … 5.8% at General Motors (GM, Rated “B”) … 6.6% at Fiat Chrysler Automobiles (FCAU, Rated “C+”) … and 7.1% at Ford Motor (F, Rated “C”).

Overall industry sales dropped 4.7%, the fourth month in a row of declines. That’s an ugly stretch the likes of which we haven’t seen since the Great Recession in 2009.

2. The sales slump came even as automakers boosted incentives to around $3,499 per vehicle, a record high for April, according to J.D. Power. A separate report from industry tracking firm ALG said incentives jumped 14% on average from the same month a year ago.

3. The slowdown in current sales – and past overproduction designed to meet artificial demand driven by too much easy credit – has left automakers buried under a mountain of metal. GM had a whopping 100 days’ worth of inventory as of the end of April. Automotive News also reported that brands as wide-ranging as Chevrolet, Mitsubishi, Acura, VW, and Jeep had at least 90 days of U.S. inventory on hand. Numbers around 60-70 are considered normal.

4. As if that weren’t enough, auto loan delinquencies are on the rise – with late-payment rates climbing toward levels we haven’t seen since the Great Recession. Used car prices are also plunging, decreasing the residual value of repossessed cars and increasing lender loss severity on each defaulted loan.

This chart shows that a NADA index of used car prices fell another 0.3% in March. That left it at its lowest level since September 2010.

5. All of that is (belatedly) causing lenders to tighten lending standards again. Some 11.7% of banks surveyed by the Federal Reserve tightened car loan standards in the first quarter on net. That was up from 3.3% a quarter prior and the highest since all the way back in Q4 2009, as you can see in the chart below.

When lenders pull in their horns, it makes it harder for potential buyers to get financing. That puts even more downward pressure on sales, profits, production, and employment in the auto sector.

6. How bad could losses get for banks, specialty lenders, credit unions, and the captive auto financing arms of major manufacturers? Well, many lenders have been extending financing for as long as 84 months. My research recently turned up at least one willing to go all the way out to 108 months – nine long years.

Many have also been willing to extend credit at loan-to-value (LTV) ratios of up to 120%. I found at least one that would go all the way up to a 140% LTV. That’s $14,000 for every $10,000 of car value. A key reason is that they have no other way to get borrowers into new vehicles.

Result: More borrowers than ever before are “upside down” on their existing car loans, or owing more than their cars are worth. Plus, the dollar amount of so-called “negative equity” is at a record high. It’s a recipe for disaster for borrowers and lenders alike should anything shut off the flow of credit to the sector, just like the credit crisis eventually did to the high-risk mortgage lending industry.

In sum, specialty finance companies, Main Street lenders, Wall Street loan securitizers, average borrowers, Federal Reserve policymakers, and other parties have made the same mistakes in autos over the past few years that they made more than a decade ago in housing. There is simply no way this ends well.

So I will continue to closely follow this increasingly important topic and keep you updated. It has vast implications for your investment portfolios and personal finances, and could ultimately cause major issues for the financial system and related stocks down the road.

In the here and now, the latest news is only worsening the notable underperformance among some of the largest auto manufacturers and parts suppliers. Just look at this Stock Screener I created using the tools available at the Weiss Ratings website. I sorted by year-to-date return in ascending order, and you can easily see how badly these names are performing relative to the S&P 500:

Data as of: 05/03/17

Six out of 10 of the screened stocks are down year-to-date, with mega-capitalization stocks like Toyota and Ford showing mid-to-high-single digit losses. The group as a whole is showing an average return of just 2.4%, compared with a rise of 7.3% for the SPDR S&P 500 ETF (SPY, Rated “B”).

So my advice continues to be simple: Stay away from this sector! Unlike defense, infrastructure, BDCs, and even generalized financials, it doesn’t have economic or policy-driven forces behind it. Plus, it’s the single-most vulnerable to a “Black Swan”-style meltdown depending on what happens in the credit markets later in 2017 and beyond.

Until next time,

Mike