The U.S. auto industry nearly died in 2009. Thankfully it didn’t. With the help of taxpayer money, cheap credit, and a gradually improving economy, car sales and auto industry stocks bounced back. New car sales topped 17.5 million last year, smashing pre-recession highs.
The industry now makes up 3% of GDP and employs 5% of the workforce. It’s also America’s biggest export industry, reaching $775 billion in 2016.
Smart investors have gotten rich off the rebound. General Motors (GM) stock stood at $35.75 at the time of writing, a 13.3% jump from August 2016. Fiat Chrysler (FCAU) has gained in value by nearly 34% in the past year. On the other hand, the Ford Motor Company (F) has had a rough 2017.
Running on Subprime Loans
After hearing all that good news, you might wonder why so many analysts are bearish on the auto industry. There are a couple reasons why.
Firstly, domestic auto sales are basically driven by debt, not rising household incomes. In 2016, outstanding auto loans amounted to more than $1 trillion. To put that in perspective, total student loan debt stands at about $1.3 trillion.
Making matters worse, a lot of the new loans are subprime. That’s fancy talk for loans given to borrowers with credit ratings so low they can’t get a loan from a bank. Subprimes have high interest rates, which creates a self-fulfilling prophecy: Borrowers get subprime loans because lenders expect them to default. Subprimes have high interest rates, which makes default more likely.
The Auto Industry is Oversupplied
People are buying a lot of cars, but demand isn’t keeping up with supply. Inventories reached 76 days’ supply in April 2017. That’s the largest inventory since 2004, meaning dealerships are receiving cars faster than they can sell them.
The average car spends about 74 days on the lot before being sold. The problem is only going to get worse. Lots of 2016 models remain unsold, clogging things up for the new 2017 models. Auto dealers are desperate to unload inventory, and they’re now offering cash incentives of upwards of $10,000.
Given that dealerships are basically paying people buy new cars, it’s a good time to buy one. For the exact same reason, it’s a bad time to invest in the big car manufacturers.
Exacerbating the oversupply problem is the coming wave of subprime loan defaults. The defaults will make it harder for consumers to get credit, which means fewer people will be able to buy new cars. Plus, the repos will lower prices for used cars, a double whammy for dealerships. They’ll start refusing to accept new inventory from manufacturers. An auto industry slowdown will follow.
Time to Go Short on Auto Industry Stocks
The good news is, there’s a good playbook to follow. Step one: Don’t keep your fingers crossed for good news out of the auto industry. It won’t come. Limit your exposure now. Step two: Look into shorting auto industry stocks. That means borrowing a stock—in this case an auto stock—from a broker. Then, immediately sell the stock at its current market value. Next, wait for stock’s value to bottom out, buy it back, and return it to the broker. And finally: pocket the difference.
Smart investors could also make money by shorting auto lenders, who will suffer from defaults. Some of the biggest lenders include Capital One, Santander, and Ally Financial.
Capital One (COF) is already sagging on the NYSE, losing 13% of its value over the past six months. Santander Consumer USA Holdings (SC) took a big hit in May after it came out that the company had verified the incomes of only 8% of its recent borrowers. By contrast, General Motors’s AmeriCredit lending unit did due diligence on 64% of its borrowers.
We’re not looking at anything comparable to the 2007-2008 mortgage crisis. However, all signs point to auto industry stocks being the next big short.