• Blinders Off Research

This Is Not How It Ends

Updated: Jan 30, 2019

By it, I mean the current auto cycle. Before I get started, I’ll answer a good question often asked by my clients, How could you be wrong? If a worst case scenario plays out with the current trade and tariff negotiations, I will be. However, as I write this today, the final outcome of these negotiations (no matter how scary) is still unknown and uncertain. At times like this, I find it best to focus on what’s known but perhaps not fully understood.

Consumer Demand

As I’ve mentioned before, used vehicle values are incredibly important to the health of the automotive industry. I am providing an update on this topic primarily because I was recently really taken back by an article quoting an expert saying that used-vehicle prices are on pace to depreciate by 20% this year compared to a normal rate of 15%. In reading this, one would think that used vehicle prices are performing very poorly which, if true, would have a very negative impact on the auto industry as a whole. However, this statement could not be further from the truth. For an unbiased and respected third-party opinion, consider the recent 2018 forecast published by J.D. Power that states used vehicle values have been “exceptionally strong” through the first half of 2018 and projects an increase in used-vehicle prices for the full-year.

I’ll now present you with the used-vehicle value data which I’ve collected this year using my proprietary mix of vehicles.  The first chart compares the value of all of the vehicles which I follow at the end of each month to the value at the beginning of 2018.

As you can see, the group of vehicles as a whole has yet to depreciate this year. The following chart provides a bit more color by breaking up the value data into vehicle segments.

Folks, used vehicle values have indeed been exceptionally strong this year. The car category is a clear standout for reasons stated here. I said it before, and I’ll reiterate it again: The used-vehicle value performance that we have witnessed this year is a significant tailwind for the auto industry.

Volume and Margin

As previously mentioned, inventory fluctuations can be very telling. I’ll use the following analogy to explain: Think of production as water being poured into a funnel (retail dealers) at a steady rate. The water being released from the funnel represents retail sales. If  supply (production represented by the flow of water entering the funnel) and demand (retail sales represented by the flow of water escaping the funnel) are equally matched, the water level inside the funnel will remain unchanged. Something important to understand at this point is that the water flow (production) is not easily adjusted on short notice. For this reason, incentives are used by manufacturers as a short-term solution to increase sales should the funnel begin to backup. If incentives fail to regulate the flow of water escaping the funnel, the flow of water entering the funnel will need to be adjusted (production). By keeping an eye on the water level, accurate assumptions can be made for both the trajectory of incentives which impact margin and production otherwise known as wholesale volume.

We can use the events witnessed in 2017 as a great example. In the beginning of the year, the flow of water escaping the funnel slowed (retail sales), the water level in the funnel rose (dealer inventory), incentives failed to bring the water level back to normal, and as a result, the flow of water being poured into the funnel (production) had to slow half way through the year. As the year went on, a combination of hurricanes and a slower rate of production brought the water level back to normal.

To better understand what is happening in 2018, please consider the following chart comparing the total retail inventory amount at the end of each month to the total inventory amount at the beginning of 2018. Think of the 0% line as the proper water level in the funnel and the retail SAAR line as the flow of water escaping. Can you make an assumption for the necessary flow of water (production/wholesale volume) and the level of incentives (margin) needed to bring the water level back to appropriate levels?

For me, the answer is obvious. I believe that incentives will fall in the coming months and production will need to increase to meet consumer demand. For this reason, unless the trade and tariff negotiations go horribly wrong, I believe the market’s perception of quality auto companies is extremely detached from reality.

In my professional opinion, this is not how our current auto will cycle end. The analysis that I’ve shared with you today was done with the aid of what I consider to be the best leading indicators for the auto industry, used vehicle values and inventory fluctuations. Thank you for taking the time to read this and as always, I hope the content of this article was helpful.

These are my opinions and the content contained in or made available through this article is not intended to and does not constitute investment advice. Your use of the information or materials linked from this article is at your own risk.