It’s a death spiral.
Every few months there’s a down leg.
Then another drop a little worse than that.
Then another one worse than before.
Then, it’s all over.
This death spiral just got it’s third or fourth down leg and it’s going to take a lot of stocks down with it.
A Real-Time Debt Bubble And Bust
The crisis I’m talking about is in the auto industry.
If you’ve been reading these pages, you’re well prepared (read: not holding any auto-related stocks).
Last month the death spiral of the auto market took another step down from which it may never recover.
You see, in July pretty much every major auto company posted sales well below forecast.
Some drops were small. GM (GM) posted a 1.9% decline in sales below a forecasted 1% decline.
Other cases were much worse. After subtracting low-margin fleet sales, Ford (F) sales dropped 6% compared to the same month a year ago.
Those seemingly small drops in sales will have far-reaching consequences for two main reasons.
First, manufacturing is a high fixed cost business.
The megafactories where cars and trucks are built cost billions of dollars and take decades to recoup the initial capital outlay.
The auto industry isn’t anything close to tech where a company like Facebook (FB) with costs of $2.8 billion and revenue of $6.4 billion last quarter.
Free cash flows are much smaller and margins for error are razor thin.
As a result, a downtick in sales can be really bad.
A drop of 10% or 20% in sales can be catastrophic.
After last month’s sales data, the end result is looking at somewhere between bad and catastrophic.
And that’s just part of the problem.
The other part of the problem is the debt-driven auto sales market.
We summarized the impending problems almost two years in When Will The Auto Bubble Burst?:
Today the average duration of an auto loan is 66 months. That’s longer than it ever has in U.S. history. The last time auto sales peaked in 2001 the average duration was 46 months.
Not long ago a 60 month car loan was the longest you could get. And the 60-month deal was largely reserved for brand new cars. The average used car loans were a year or two shorter.
A lot has changed. Today the fastest growing duration loan is seven years or 84 months. This duration now make up 19.5% of all new car loans.
The rise of long duration loans helps current sales by pushing down monthly payments for a new car. But it also brings a lot of people who would wait to buy a new car forward in the sales cycle by a few years. So when the hangover does come, you can bet it will be a big one.
The final factor driving sales and closely related to duration is the credit quality of the borrower.
Today the fastest growing segment of borrowers is classified as “Deep Subprime.”
These are consumers with a FICO credit score below 620. The estimated average delinquency rate for these borrowers is 40%.
Deep Subprime borrowers now make up 12% of all auto loans.
The longer duration loans basically brought new car purchases forward.
With terms of six or seven years, a potential buyer who was going to wait and save up two or three years for a bigger down payment would just buy today.
Many of them won’t be there to buy a new car in a year or two.
Lower-quality borrowers make a bad situation a worse one. These customers who would have to buy a used car are now able to buy a new car.
Many of these borrowers won’t be buying new cars in two or three years where they would have too.
On a macro level, these two factors mean millions of future sales were simply brought forward to today.
That’s why we see July’s poor sales month as something that will become standard news in the months and years ahead.
Anything associated with the industry could get hit hard.
The first companies to suffer we identified were the lenders.
The most focused auto lenders are Ally Financial (ALLY) and Santander Consumer Financial (SC).
Not surprisingly, those stocks are down 24% and 60% respectively in the last two years.
As the spiral continues, they and everything else attached to the auto sector will go down with it.
That’s why if you’re seeing value in the auto sector stocks right now, please hold off.
The big automaker stocks are posting P/E ratios in the low single digits.
They look cheap. Darn cheap.
In this case though, they’re cheap for very good reasons and in all likelihood will get a lot cheaper in the years ahead.