The Auto Loan Market Seems Weak

This article will describe the two recent trends I’m noticing in the economy. Then I will refute part of a list of arguments made against using the Shiller PE as a reason to have a cautious stance when analyzing stocks.

The first trend is related to the auto loan bubble; sales look like they topping. This doesn’t mean a crash is incoming necessarily, but it should be watched closely given the large amount of subprime loans doled out. While the housing crisis acted as a catalyst for a recession, I think a recession is needed to push the auto loan market lower. The second trend is related to the continued positive survey results. The newest great survey is from the Philly Fed. It signals to me that both January and February were good months for the economy. The positive sentiment in December accurately predicted an improvement in the economy even though some of the hard data showed weakness.

The trend towards the auto market slowing was shown by the January retail sales report which showed a 1.6% year over year decline in seasonally adjusted light vehicle sales. With the recent large increase in the percentage of loans going to those with low credit scores, it looked like the auto dealers were scraping the bottom of the barrel to make their numbers. December also had record high incentives. The reason why incentives increase is because demand is starting to soften. I mentioned in my last article that January may have seen weakness because of a decline in incentives, but I didn’t have the metrics. It’s important to understand that if sales declined because of a less discounting, this is a good sign. Discounting was at an unsustainable level. It would be good if a decline in incentives only caused a small decrease in sales.

Without seeing the metrics, I thought discounting declined. It did decline. January price incentives fell 3.3% from December to $3,635. However, because December’s discounts were so high, this still represents a 22% increase from last year. Discounting and sales only tell a part of the story for the auto market. The other parts are the increasing inventory and delinquency rate which is a perfect storm for the demise of the industry. As you can see from the chart below, the average debt per car loan buyer has skyrocketed to about $18,000 as some consumers have bought cars they can’t afford. The car loan delinquency rate is a few ticks away from the highs seen in 2009. Rising interest rates will hurt sales as consumers can barely afford the cars they are buying with interest rates near zero percent.

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The Philly Fed Manufacturing survey was extraordinarily great. I don’t use those words lightly. It was the highest reading since 1984 and beat expectations by the most since at least 1998. The index increased from 23.6 in January to 43.3 in February. This beat the MarketWatch economist consensus of 20. It was the biggest one month gain since June 2009. I have said that new cycles don’t emerge at the end of old ones without first having a recession. However, this burst in the Philly Fed Manufacturing Index is proving that assertion wrong.

The chart below shows the historical data of the index. In past economic reports, the current activity has been much weaker than forecasted activity as hope ruled the day. Now we’re seeing current activity spiking higher. New order growth was the biggest cause of the improvement. 43.9% of firms reported having an increase in new orders over last month. The diffusion index increased from 26.0 to 38.0. Another interesting piece of information is the prices paid diffusion index fell 2.6 points and the prices received diffusion index fell 16.2 points. The rate of inflation appears to be moderating in this survey which is great news. While investors want inflation because it shows an increase in demand, they will soon switch to fearing it as it can quickly turn into a problem. The idea that inflation would rise to the level of the 1970s isn’t in the cards, but higher interest rates hurt the economy more than in the past because of the high amount of government, consumer, and corporate debt.

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Whenever valuations become high, the argument against them always seems to pop up. Personally, I can’t buy an overvalued market based on excuses to support a narrative. Discipline comes into place when momentum rules the day. An analogy for this situation is a baseball pitcher who is erratic. He can’t throw strikes, so he walks a few batters. Then the next pitcher who replaces him also can’t throw strikes. Your teammate tells you this is a new paradigm. He tells you pitchers don’t throw strikes anymore, so you should swing at balls. The current market is expensive. A bullish investor can claim that fairly priced investments don’t exist anymore. I don’t believe that idea. I’m willing to wait for strikes.

I will respond to the first couple of points in the screenshot below which argues against valuations. In my next post, I will respond to the rest. The first two points claim that because firms are more productive per employee, it means stock valuations should be higher. This a logical fallacy because the increased productivity is already accounted for by the higher earnings. I don’t value stocks by the number of employees they have; I value stocks by their earnings. It’s great that Facebook can profit with so few employees, but that doesn’t mean its earnings are worth more; it means it has more earnings. That’s a distinction which invalidates the first two bullets.

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Conclusion

The auto sales rate appears to be peaking. It would be more concerning if the economy was weakening because it would add to its woes. However, as we see from the Philly Fed Manufacturing Index, the economy is strong. I’m interested to see what business owners feel Trump needs to achieve to validate their optimism. He has promised to cut regulations and red tape which delay business investment. I think this is more important than tax reform. On another note, the stock market is expensive. Investors are coming up with faulty reasons to justify buying stocks that have high price to earnings ratios.

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