For Auto Companies, This Is As Good As It Gets

Includes: AAP, ALV, AZO, F, GM, ORLY, TRW
by: George Kesarios

Low rates produce extra income for consumers that would otherwise have not been available to them with higher rates. Higher interest rates will therefore have the opposite effect, and will extract that extra income from consumers, which was given to them, not by an act of God, but by an act of the Fed.

But just as the Fed giveth, the Fed can taketh away. And the time that the Fed will be taking away is getting nearer. Tapering is not just talk, but something that will inevitably happen. And because the market knows this, it has been front-running the fed for a while now. The 30-year conventional mortgage rate stands at 4.46% and rising.

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The chart above shows the average finance rate for new auto loans. As you can see, while it was under 3% in the beginning of 2009, today rates are approaching 5% and rising.

Granted 5% is not a whole lot, and so far auto sales have been doing very good, but please keep in the mind the market is forward looking. This means that the market is looking ahead and not the past, or even what is happening today.

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And indeed, car manufacturers (chart above) like General Motors (NYSE:GM) and Ford (NYSE:F) have benefited greatly by ultra low rates. But if these ultra low rates go away -- as they seem to be doing -- then that will have an impact on sales sooner or later.

Now let's also look at another chart.

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The above chart is very interesting, and I think it is the single most important evidence that indicates the limits of current Fed policy.

LTV ratios are used to assess risk when making loans. The higher the LTV rate, the higher the interest rate of the loan, and the lower the LTV rate, the lower the interest rate paid.

As the chart above from the Fed shows, the LTV ratio for new car loans is at record low levels. What this means is that risk of default is perceived to be very low and therefore interest rates overall are quite low.

And because risk is perceived as low, auto financing is widely available. In fact today auto financing is available to just about anyone for the asking. Almost anyone who has two legs qualifies for an auto loan today (well almost).

That is one of the reasons why car manufacturers have been selling a lot of cars lately. And these good auto sale numbers have a lot to do with Fed accommodation. Take the accommodation away and chances are that the reverse will happen ... higher rates will lower auto sales.

And the reason why auto financing and auto sales are probably as good as it gets, is because rates were as good as it gets, default rates are as good as it gets and risk is as good as it gets. In other words, we are at the end of the cycle. And the only expectation we have from now on is when rates will go up.

This means that it might be time for investors in car manufacturers like Ford and General Motors to take some money off the table. Ford especially has returned good money from its lows and any deviation from analyst expectations might send both of these stocks to much lower levels. But it's not just car manufacturers that will be affected.

The same also applies to auto part manufacturers like TRW Automotive (NYSE:TRW) and Autoliv (NYSE:ALV), as well as auto part retailers like Advance Auto Parts (NYSE:AAP), AutoZone (NYSE:AZO) and O'Reilly Automotive (NASDAQ:ORLY).

In fact the entire auto food chain will be affected by higher rates, when the Fed begins to scale back asset purchases. And I don't think the Fed will put it off this time. There are limits even for the Fed on how much it can accommodate before it really misaligns risk perception, and I think they realize that the end of the line is here.

Just how much the Fed's decision will affect the auto industry is uncertain, but I think the downside over the next several quarters might surprise us.

In addition, all the stocks mentioned above have had a good run-up over the past several years. Even if things don't turn out as bad as I think, it's not a bad idea to sell and stay on the sidelines every now and then. And because institutional investors have made good money in these stocks also, they might also decide to cash out. So selling today is a good way to front-run them.

Right now I am recommending taking money off the table in the sector simply as a precaution. However, over the next several months and quarters, I think it will prove to have been a very good strategic move.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.