Peak Auto Part II: The Classic Economic Cycle

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by: Eric Basmajian
Summary

Auto sales have likely peaked for this economic cycle.

A simultaneous contraction in auto sales, housing data and big-ticket consumer spending is part of how the classic economic cycle develops.

As a composite basket, autos, housing and durable goods consumption have contracted for the first time this economic cycle; a warning sign for the health of the business cycle.

Peak Auto Part II: The Classic Economic Cycle

Total vehicle sales is one of many classic leading economic indicators of the business cycle. Vehicle sales historically peak preceding recessionary periods due to the relatively large sticker price of the good in the consumer basket, the sensitivity to interest rates, and the economic concept of pent-up demand.

Classic economic indicators that tend to lead turning points of the business cycle have these three characteristics.

I wrote an article several weeks back, "Peak Auto" that discussed these trends and linked the data to several popular auto stocks. These trends are also topics discussed in great detail in my marketplace service, EPB Macro Research.

Other indicators that fall into this bucket include housing and big-ticket consumer products such as home appliances which can be proxied through durable goods consumption, found in the personal income and outlays report released by the Bureau of Economic Analysis.

While I will only touch on housing and durable goods consumption very briefly in this note, both of those categories, in combination with auto sales, provides one of the best baskets of leading indicators for the classic business cycle.

A peak and subsequent decline in auto sales, housing sales and durable goods consumption that is pronounced and persistent has historically led nearly every business cycle.

As with all leading indicators, there are times throughout history where one indicator as a stand-alone metric fails to forecast the business cycle. This, of course, is the case as if it were not, we all would have found the one metric that predicts every turning point. This is clearly not a realistic assumption so when looking at leading indicators of the business cycle, we must look at these three critical sectors in combination. While one indicator may fail, the probability of all three of these sectors providing a false signal is significantly diminished.

The reason these three sectors are such reliable indicators of the business cycle (note: I continue to say business cycle, not stock market), is due to the factors listed above: high ticket price, sensitivity to interest rates and subject to pent-up demand. While the stock market can deviate from the business cycle for a period of time, should you have the ability to spot turning points in the business cycle, you will significantly reduce your risk of large drawdowns in your portfolio as you will be prepared for times when risk is elevated. With time, the stock market converges to the economic cycle.

Items that have a high sticker price tend to get reduced first in terms of consumption as the consumer starts to feel tight. A consumer will not be able to make a large ticket purchase unless they are feeling prosperous. Secondly, all three of these items are more often than not purchased with some component of financing. As the economic cycle comes to an end, the Federal Reserve starts to raise interest rates, thereby making the cost to finance big-ticket items relatively more expensive. Lastly, the economic concept of pent-up demand applies to these three categories meaning that once pent-up demand has been exhausted, these industries are left with overcapacity, and price reductions as employment lay-offs amplify the trends in the data. If a business cycle lasts 10-years, once everyone has a car, consumers will not endlessly purchase new cars. If everyone who wants a new kitchen has already put in a new kitchen, and now interest rates are rising and the cost of a new kitchen (home appliances) is increasing, a notable slowdown in durable goods consumption will be seen. Consumers constantly need to buy more food or get a new haircut or pay for healthcare so these baskets of consumption, while subject to declines during periods of stress, are less discretionary and less volatile with the cycle.

With that said, let's take a look at the state of auto sales, touching briefly on housing and durable goods at the end of the note.

Based on the supplemental estimates data from the BEA, total vehicle sales in January fell to 17.089 million units on a seasonally adjusted annualized basis.

Total Vehicle Sales (Millions):

Source: BEA, EPB Macro Research

Data provided by the Autodata Corporation shows that total vehicle sales fell to 16.70 million units by the trend is exactly the same.

Total Vehicle Sales (Millions):

Source: AutoData Corporation, EPB Macro Research

Total vehicle sales have peaked for this economic cycle and have started to decline, a very telling sign for this economic cycle indicating that pent-up demand for new autos has likely been exhausted.

The data from the AutoData Corporation shows that total vehicle sales peaked for the cycle in November 2015 and have declined since then. 39 months later, total vehicle sales are lower than in 2015, a very telling sign for the economic cycle.

Again, vehicle sales as a stand-alone measure can provide false signals and we will look to the other sectors that typically move in a similar fashion for corroborating data.

Lightweight vehicle sales make up over 95% of total vehicle sales so breaking out small autos and small trucks will show the exact same trend. An interesting component to look at within total vehicle sales, a highly cyclical sector, is heavy weight trucks. Heavyweight trucks is a very sensitive economic indicator.

The chart below shows that heavyweight trucks peaked well before each economic recession.

There are several times when heavyweight truck sales declined in a pronounced fashion and while those periods did not result in a recession, they were most certainly times of sharply reduced economic activity, such as 2015-2016 when there was a global industrial recession.

Heavyweight Truck Sales (Millions):

Source: BEA, EPB Macro Research

In terms of forecasting notable declines in economic activity, heavy truck sales are fairly consistent but for a confirming signal on the entire business cycle, as mentioned above, we need to look at housing and durable goods consumption.

If heavyweight truck sales decline but housing and durable goods consumption remain strong, the reduction is likely specific to the auto sector. If all three sectors start to contract in a pronounced way, economic trends have likely shifted and a loss of employment in these cyclical sectors may be on the way.

Quickly looking at the vehicle sales data shows that in year over year terms, sales are down 2.9%.

Total Vehicle Sales Year over Year (%):

Source: AutoData Corporation, EPB Macro Research

The sales of heavy trucks are up 14.6% compared to the same month last year. The heavy truck sales data is not indicating a recession is imminent, nor is the total vehicles sales data, but the broad deceleration in growth from the peak is a clear sign of reduced activity in this sector.

Heavyweight Truck Sales Year over Year (%):

Source: BEA, EPB Macro Research

If total vehicle sales are down compared to last year, we are likely to see a reduction in new orders, production of cars, and employment which are starting to become more evident in some of the leading indicators, covered at length with members of EPB Macro Research.

The probability is rising that we have hit peak auto sales for this economic cycle. That is a negative sign for the economic cycle as a loss of employment in the auto sector typically follows. In the coming months, we will study the employment trends in auto sales, housing, and durable goods production.

Before concluding, let's very quickly take a look at the trends in housing, and durable goods consumption. If all three sectors are contracting at once, we should exercise extreme caution as business cycle risk would then be meaningfully elevated.

The housing sector has hundreds of data points but we can narrow it down to three time-tested, popular and reliable data points: newly issued building permits for new construction, the volume of newly constructed home sales, and the volume of existing home sales. These three indicators cover the construction market, the new home sales market and the existing home sales market. Each data set is relatively noisy compared to most data but it is the overall trend that we are most concerned with.

In terms of building permits, we have seen a 4% contraction from the peak to current levels, at one point declining 9%.

Building Permits:

Source: Census Bureau, EPB Macro Research

Newly constructed home sales are down 8% from the peak in November of 2017, at one point contracting a whopping 21%.

New Home Sales:

Source: Census Bureau, EPB Macro Research

The volume of existing home sales has contracted 13% since November 2017.

The peak in the new home sales and existing home sales in terms of volume of sales both came in November of 2017, another point of consistency across the trending data.

Existing Home Sales:

Source: NAR, EPB Macro Research

All three data points are showing contraction relative to the peak in a fairly pronounced fashion.

Lastly, the growth rate of durable goods consumption has declined meaningfully. This data is highly delayed and as of the November reporting period due to the government shutdown.

Durable Goods Consumption Year over Year Growth (%):

Source: BEA, EPB Macro Research

Currently, we have a situation where auto sales have peaked, the housing data has peaked and durable goods consumption is decelerating notably, near the lowest growth rate of this economic cycle. It is not the decline in each individual data point that is telling, it is the trending direction of the aggregate data in these economically sensitive sectors.

This sequence of events is highly classic.

The only way to have a truly objective measure of this data to compare across time is to compile these data points into a composite index.

Members of EPB Macro Research recently got a look at one of the composite indices that I use to gauge the health of the business cycle. This index takes total vehicle sales, building permits, new home sales, existing home sales and durable goods consumption, adjusts each metric for standard deviation and aggregates one index.

This classic business cycle index provides a completely objective view of the stage of the business cycle based on these five time-tested reliable indicators.

As I wrote at the start, each one of these five indicators can fail at turning points, but the probability of all five of these indicators moving in the same direction and not indicating something meaningful in the economy is very low.

We are not near a recession, that is not in the US economic data yet, but the probability that the business cycle is coming to an end is rising based on the trends in these time-tested economic indicators. It will be hard for the economy to escape a meaningful deceleration in economic growth if auto sales, housing sales, and durable goods consumption continue to decline from peak. If not for a broad-based deceleration in economic activity, why would these three sectors start to contract at once?

Disclosure: I/we 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.