On Tuesday, September 10, Ally Financial (NASDAQ: ALLY) shares got crushed by 18% when the company admitted that loan delinquencies and charge-offs rose to levels higher than what the company expected. Delinquencies are defined as loans at least 2 months overdue. Charge-offs are loans a company thinks will never be paid back.
Of course, lenders put aside cash to cover expected losses – loan loss reserves. Problems start when companies realize they aren’t putting enough aside. Funneling cash to cover non-performing loans means fewer loans can be made. Rising delinquencies and charge-offs lower the value of the loan book which means the company itself may have a harder time borrowing money in the bond market. Investors might start to worry about a dividend cut…
Don’t forget: it was Meredith Whitney’s October 2007 prediction that Citi would cut its dividend that kicked off the Great Financial Crisis. The GFC itself boiled to down loan quality – portfolios of mortgage bonds weren’t worth what investors thought they were and that brought the whole house of cards down.
Now I’m not suggesting that the news from Ally is a corollary to the GFC – at all. Ally is an auto loan company, not a mortgage company. Auto loans is not a big enough market to bring the U.S. economy to its knees. Outstanding auto loans total around $1.5 trillion, about a tenth of the $12 trillion of mortgage debt outstanding.
Still, you should pay attention because Ally’s is still very significant, for several reasons…
The Weak Consumer
Rising delinquencies for consumer credit are a canary in the coal mine for an economy that is +70% dependent on spending. If you can’t make current payments, you’re certainly not taking on new payments to buy new stuff.
This is how the Fed’s interest rate hikes are supposed to rein in inflation. Higher rates make loans more expensive, which slows down lending, and falling demand lowers prices. You wanna see used car prices fall? This is how it happens.
It’s a general rule that higher interest rates take a year to 18 months to start working, to start weighing on the economy. We are past that point now. Why has it taken so long for the Fed’s rate hikes to start working? One reason is the amount of savings people built up during the pandemic. Now that those savings have been spent, and credit lines are maxed out, demand is finally falling…
But the conditions for demand to fall have been evident for months. Not only have savings and available credit been used up, unemployment has been rising since March!
Of course, the Fed’s singular focus on backward-looking price data means that it has ignored this rise in unemployment.
I think back to the Fed’s response to spiking inflation. After calling inflation “transitory” for 6 months, the Fed finally responded to 8% inflation with – a 25 basis point rate hike.
That’s literally a drop in the ocean. The market didn’t take the Fed seriously at all, inflation kept climbing to 9% before the Fed finally got serious about the issue and started dropping 75 basis point hikes.
The Fed is now doing the same thing in reverse. It is not taking the weakening employment numbers seriously.
The Fed’s slow response to inflation has now set the expectation that the Fed won’t get serious about loosening monetary conditions until the data smacks it in the face.
When the Fed cuts rates by a measly 25 basis points next week, don’t be surprised if stocks sell off.
The Next Domino
You’re probably well aware of how Hammer and I feel about Big Tech/AI stocks. They are expensive and the path to monetizing AI is not very clear right now.
With economic growth weakening, it’s time to start looking at the risk to consumer stocks.
I don’t know if you’ve seen Dollar General lately, but wow, for a company that is supposed to be a savior for lower-income, price-sensitive consumers it has had a terrible couple of years:
The stock was $250 when the Fed started hiking rates. Recent earnings crushed the stock from $125 to under $80. Not sure I’d short Dollar General, but I sure wouldn’t buy it.
I’ve got another one you need to know about that could work as a downside play: Affirm Holdings (NASDAQ: AFRM). Affirm is one of the new breed of “buy now, pay later” companies. You’ll see the pitch on Amazon Prime, for instance, where instead of just paying for something, Affirm (or one of the others) will offer you an installment plan for your purchase…
I swear they offered to lend me money for a $60 switch I was buying for my Corvette restoration project. Maybe it’s me, but if someone didn’t have $60 for a purchase, I sure wouldn’t lend it to them. Pretty sure that’s $60 that wouldn’t be coming back…
Affirm went public at $90 in January 2021, when consumers were flush with pandemic money and the party was about to kick into overdrive as the economy opened back up. The stock made it into the $160s before the end of 2021. But things haven’t gone so well for it lately.
The stock recently spiked 40%(!) to $44 after earnings. The company apparently said it was on the verge of being profitable. Maybe that’s true…
But I can’t think of a worse business to be in as unemployment is rising and the consumer is tapped out.
Affirm is currently valued at $12 billion. The company has $5.5 billion in net debt. Analysts have penciled in $0.24 a share for calendar 2025, giving it a forward P/E of 145.
The low for the stock was $9 at the start of 2023.
If (when?) delinquencies and charge-offs start rising, Affirm share price has a long way to fall.
Cheers,
Briton Ryle
Chief Investment Strategist
Outsider Club
X/Twitter: https://twitter.com/BritonRyle
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