The auto market bubble just popped

If you were looking for a place to invest money five years ago, a car wouldn’t have been the first “asset” on your mind. A car is the textbook example of a depreciating asset because it loses value the moment you drive it off the lot. Cars lose 20% of their value in the first year of ownership and lose 10% a year annually. Five years after owning a car, it’s worth less than 40% of what you paid for it. That’s how things usually work.

But something crazy happened in the last few years – Used car values outpaced housing, art, and even the stock market as an asset with prices growing at a rate that made no sense. Overnight, cars went from being a utility to a speculative asset, with people financing cars at absurdly low interest rates and flipping them. When interest rates began to go up, car prices still seemed to be following at the same rate.

But now, car prices are seeing their largest decline in a decade at a time when interest rates are the highest in over 20 years. Electric vehicles are selling for 32% less than a year ago. Owners are beginning to fall behind at an alarming rate, and there’s more to come, with soaring default rates among millennials and Gen-Z. How did the auto market go from such a sweet spot to a complete reversal in less than a year?

There’s a lot that people aren’t talking about, and to understand how this is going to grow into a bigger issue in 2024, and how you can “drive out” ahead, we need to go back to how it all started.

Why is there a bubble?

Until recently, 80% of new cars were selling above MSRP. What made cars the best-performing asset since shorting WeWork? There were four main reasons, and it started with the pandemic:

1. The chip shortage: Cars these days completely automate everything from windows and sensors, to ignition and navigation. But this automation is completely reliant on chips with each car using several thousand of these to function properly. The global chip shortage triggered by the pandemic hit the auto industry hard. Now, the auto industry consumes only 3% of the global market but with consumer electronics seeing a record surge in 2020 and 2021, supply was diverted away from automobiles. Meanwhile, a lack of labor and a supply chain crisis led to manufacturing delays, and fewer cars were built, due to a lack of chips.

2. Low interest rates: Till the beginning of 2023, you could lock in a 12-year loan to buy a car at record low rates – which made cars more affordable to purchase. But at the same time, this also pushed up demand for car loans and today, monthly payments are at $736, the highest they’ve ever been. The more purchasing power Americans had, the more prices soared, and now auto loans come in at $1.5 Trillion, just behind home loans and education loans.

3. Sticky buyers: The housing market is going up because buyers were able to lock in mortgages at the lowest rates in a decade and they have no interest in trading for a worse rate. The same’s the case with cars, per Jalopnik. If you’re perfectly happy with the car you drive, why get a brand new car with a brand new car loan and brand new problems?

4. Greed: When automakers saw that less supply meant that prices were going up, they did the logical thing – they started making less cars and charging more. I don’t even need stats on this one, because automakers are fessing up themselves, with BMW saying they plan to “clearly stick with the way we manage supply to keep our pricing power at the current level.” KellyBlueBook also ran an article, explaining that manufacturers will “consciously undersupply demand” to keep prices high.

But the cracks are beginning to show:

Falling prices

It might not be obvious that we are in danger, because cars are still more expensive today than they were prior to the pandemic. But it’s clear that we’re on a downward trend. For example, the website CarGurus which tracks millions of used car values on a daily basis found that prices have fallen by more than 1% in the last 30 days.

The biggest declines came from Teslas: Prices are now less than 33% compared to a year ago. Tesla supposedly slashed off prices to drive sales, and this might have forced other EV makers to drop prices to remain competitive. This is the first time that used electric vehicles are outnumbering new cars for sale and used inventory is itself taking away the market for new cars. Beyond this, year over year:

Crossovers are down 5.7%
Hatchbacks are down 8.86%
Wagons are down 9.28%
Vans are down more than 11%

Only coupes and convertibles are up almost 0.5 to 1% in the last 90 days. Now that the downward trend has started, the question is, how far can prices fall and why is the entire industry at risk?

Broken incentives

If only one section of the business was affected by the bubble, say customers who overextended on cars they couldn’t afford, then it wouldn’t be so catastrophic. But all the dominoes are placed in such a way that if one falls, it’s going to topple over the others. There are four parts to this:

The dealerships
The auto loan bubble
The repos
The bank defaults

It starts with the dealerships. The cars that dealers buy aren’t paid for with cash – instead, they depend on lines of credit that they clear when the sale is made. Every day that the car is on the lot costs the dealers money. But with interest rates shooting up, a pick-up truck that cost $2-4 to hold now costs $12 a day for the dealer. It’s a double-edge sword – if they panic and sell, they’d lose money on a bad deal but the longer they hold, the more the interest piles up bringing in a loss even on a good deal (If you want to learn more, it’s explained beautifully in this video by CarEdge).

Next, let’s look at the buyers. We talked about how cars are depreciating assets losing 11% when you drive them off the lot and 63% over five years. This makes sense, because wear-and-tear and improving technology make a second-hand purchase less of a bargain. But the last 3 to 4 years were an anomaly – money was cheap, demand was high, supply was low, and banks would lend without batting an eye even for a $50,000 Corolla.

Now, if buyers want to trade in the car, they’d be underwater by $6,000. Imagine taking out a $40,000 loan on a car now worth $20,000 and being unable to afford the monthly payments – you’d have to sell at a heavy loss, you can’t refinance at higher rates. Because of this, car repos are at an all-time high. Over 6.11% of subprime auto borrowers are late on payments by 60 days or more, the highest recorded since 1994. Now this means that buyers are giving up the car, walking away, and letting the bank take the loss.

With repos increasing, banks are preparing for defaults. Banks are now way more careful about whom they lend money to, making it hard to get an auto loan and also leading to an increase in the interest rates. Auto loan rejections are also occurring at the highest rate in 10 years, according to CarEdge, and banks are writing off some loans as complete losses. CNN predicts that this is just the start and that auto loan delinquencies will peak at 10%. Car payments are even exceeding rent for a portion of millennials and Gen Z.

ZeroHedge calls this the perfect storm: Buyers took out excessive loans that they couldn’t afford on cars that weren’t worth the price they paid for them.

Now what does this mean for you?

Buy or give back?

Car values are still falling. If you’re planning to buy soon, that’s great news because it gives you the upper hand (except for pick-up trucks which are getting slightly more expensive). If you’re planning to buy a used car, the value for money might be a little tricky – according to CarScoop, “Used car shoppers have to buy cars more than twice as old as what the same money bought them in 2019.” These cars are not only older, but have between 40,000 and 100,000-plus more miles on them. But a car as an investment might not be a great idea – buy only because you need one, because car prices could still fall from here.

On the other hand, one search term is trending now at its highest level in history: “Give my car back.” According to Lucky Lopez, a growing population of car owners are just walking away from their cars because they owe more on them than they're worth. Even though this isn’t quite like “the 2008 housing bubble” where consumers took on adjustable rate loans on stated income, there’s surely a large number of people who can’t sustain $700 car payments in the face of rising prices, higher interest rates, and increased unemployment.

If you’re in a place where you’re underwater on a loan that you can’t pay back, it might be worth it to try talking to the bank and renegotiating your payments. It doesn’t hurt to ask – and now banks are in a situation where they’re taking losses left and right, so they might be willing to settle for something rather than nothing.

If you’re selling a car, I’m not an expert, but good pictures, proper exposure on the internet, and a realistic comparison with existing options always helps.

If you’re buying a car, now is your time to negotiate. The market is turning in your favor. Use that to your advantage, and I wish you luck with a good deal!

At the end of the day, remember that a car is not an investment, and buying in the hope of the car’s value increasing over time doesn’t make sense. The sooner you come to terms with buying a car being a money-losing proposition, the faster you’ll realize that return on investment doesn’t factor into the equation and maybe you’ll think twice when a dealership tries to charge $100,000 for a Toyota Rav 4.

That's it for this week. I hope you enjoyed this article. Let me know your thoughts by responding to this email - I read every single comment :)

Stay safe, stay invested and I will see you next week – Graham Stephan.