The Perfect Storm Hits Used-Car Values: The Foundation Of The Auto Industry Is Faltering

1) Trade Cycles and How They Affect New Vehicle Sales Velocity

Used car values determine in large the velocity of new car sales. Most new car transactions involve a trade. The level of equity in the trade oftentimes determines whether a new vehicle transaction will be successful or not. Inclining used car values lead to faster trade cycles while declining used car values lead to slower trade cycles. Dismal new car sales volume during our last recession created a shortage of used cars. This created a large supply and demand imbalance that made used car values soar from 2009 till 2014 as seen on this chart.

This time period was extremely favorable for new car sales because consumers found themselves in an equitable position on their vehicles in a very short period of time. To illustrate this, consider this chart of a 60-month loan.

The black line represents the principal balance owed. An optimal trade cycle occurs when the principal balance owed on a loan intersects with the market value of the vehicle. The bullish used car cycle for passenger cars ended in 2014 as a result of extreme pricing pressure from new car leases. Since 2014, used passenger car values have corrected and continue to underperform. This underperformance is largely due to the effects that falling used car values have had on new car sales velocity. A longer trade cycle results in a slower velocity of new car sales. Today, we’ve seen data suggesting that used car values can drop as much as 50% from current levels. Refer to the above loan chart and consider what a drop that large would mean for new car sales velocity in terms of trade cycles.

2) Increased Dependency on Leasing

Used car values also determine the effectiveness of leasing. The most significant component of a lease is the gap between the residual value and the sale price of the vehicle. A residual value is little more than a guess at the future value of a vehicle. Manufacturers and third party companies like ALG use current and historic used car value data to establish residuals. Because of this process, residual values tend to lag used car values. As residuals rise, the gap between the residual value and the sales price gets smaller leading to lower payments. As residuals fall, the gap becomes larger leading to higher payments.

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