March 2013

A PUBLICATION OF CHILTON CAPITAL MANAGEMENT

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Secondary Distortions

Home and Auto Consider the housing and automobile markets. Samuel Rines Autos and housing are credit-linked, long-lived assets with robust after-markets. Most people buy a home with a mortgage and many finance autos. And cheap credit had been spurring demand for years before the crisis. As the recession and credit crunch disrupted the demand for new goods, this all it the aftershock. Beyond the headline eventually had an effect on the secondary maritems like unemployment, falling GDP, kets, which are much larger, at least in terms of consumer spending, and so on, recessions volume, than the primary in both cases. cause distortions and overcorrections The used auto market is a critical piece of the in a wide array of individuals markets. And the auto industry accounting for between 70 and 80 consequences can linger long into the recovery percent of all auto sales. In 2008 and 2009, more years, even after much of the economic normality has returned. These distortions do not necessarily autos were scrapped than new ones purchased. This is a rare occurrence in the auto market, and detract from the economic recovery, but some do have implications for how and where the recovery has the effect of reducing the number of cars available for purchase in future secondary can go. usedmarkets. New cars outnumbered scrapped autos by around 4.75 million per year between Cause and Effect 2002 and 2007, but in 2008 more than 800,000 It often happens that the causes of a recession are more autos were scrapped than bought. By the discovered only after the fact. This was not the end of 2009, the trend had almost corrected with case with the Great Recession, which was born only 29,000 more auto scrapped. New sales again from the highly publicized financial crisis caused outpaced scrapped autos in 2010 and 2011 as the by the US subprime meltdown. A credit crisis, recovery began to take hold. coupled with a rise in the price of oil and other There were fewer new cars purchased and commodities, may well have shocked the US economy further. It was the conf luence of this tri- leased during the Great Recession resulting in ple threat against the economya financial crisis fewer future used vehicles on the roadpushing prices for used cars higher. Between December that spread quickly to consumption, exacerbated by the difficulties of commodity price shock to the 2008 and May 2011, used car prices increased economythat led to a deep and protracted reces- 30 percent. Prices have pulled back from the May 2011 peak, but remain at robust levels. Auto sion. The transmission of capital from savers to borrowers is pivotal to the functioning of a healthy sales have now returned to a seasonally adjusted economy. The Credit Crisis was the breakdown of annual sales pace of just above 15 million, though this is still below the average of 16.7 million this mechanism. between 2003 and 2006, when auto sales began

to decline. By historical standards, number of new vehicles sold continues to be low, and there is likely still some pricing pressure and relative shortage of used vehicles. Some of this recent pricing strength is likely due to the effect of Super Storm Sandy and the destruction of a couple hundred thousand cars. And there is reason to believe prices of used vehicles could remain high, and that a continued rise in the value of used cars could spillover to affect new car sales. As demand for newer, high-quality used vehicles increases, the trade-off between buying a new and used cars shrinks. Housing and Inventories When demand disappears in a recession, companies can either lower their prices or lower their output. But they cannot do either quickly. Prices are sticky, and companies cannot adjust output quickly enough to deal with slowing demand. This causes inventories to build. As inventories build, the need to produce vanishes and factories begin to slow or idle. Nowhere was the buildup greater than in housing. There was a significant amount of overshooting and undershooting on the part of buyers, sellers, and builders. But cheap credit and subprime mortgages were only part of the reason for the supply glut. Inventories and supply surpluses were also the result of foreclosures and other shadow inventory sources that caused a large backlog of housing.

market. Prices have recovered slowly and modestlyabout 6 percent, and new home sales have increased 60 percent from the bottom. New home inventory fell to 4.1 monthsdown considerably from the 12.2 month inventory peak in January 2009. Even when shadow inventory is included in the inventory, there is only around a 4.8 month supply. This could be great news for the economy. With inventory back to pre-crisis levels, there is a need for new construction to meet demand and keep inventory levels from falling too low. This should also be positive for prices, as demand appears to be robust and supply is still low by historical standards. Housing starts remain below the 1 million unit annual pace (they were around 1.75 to 2 million prior to the recession). But construction should pick up as inventory continues to be scarce. Different Distortions The auto and housing markets are in two different stages of their recoveries. The new auto market continues to heal, and used auto inventory is beginning to be restocked and prices should moderate from their elevated levels as this process continues. Conversely, the dearth of housing inventory should help prices move higher in the near-term. And with inventory levels so low, additional new construction should be needed to meet future demand. In the end, home construction and the housing market may be on the brink of a triumphant return.
Sources: US Census Bureau, New Residential Construction and New Residential Sales; US Department of Transportation, Motor Vehicles Scrapped; The Supply Side of the Housing Boom and Bust of the 2000s, Haughwout et. al; Bloomberg Auto Industry data, US Department of Commerce, Bureau of Economic Analysis, Auto Sales; National Association of Realtors

Nowhere was the buildup greater than in housing. There was a significant amount of overshooting and undershooting on the part of buyers, sellers, and builders.
When the bubble burst, housing saw both a lack of demand and a dramatic decline in prices. According to the Case-Shiller 20-City index, the peak of pricing was in April 2006, and by November 2011 home prices had declined by 34 percent. As the credit crunch took hold and banks refused to lend, the sales of new and existing homes evaporated. New home sales fell 73 percentfrom nearly a million at the end of 2006 to barely above a quarter million. Existing home sales which, like autos, represent the majority of all sales, showed the same pattern with declines of 46 percent. Now, housing inventory sits at its lowest level since March 2000, and some areas of the country are beginning to see signs of a sellers
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SAMUEl RINES is an a nalyst and Economist at chilton capital m anagEmEnt in houston, tExas. dirEct quEstions or commEnts to: srinEs @chiltoncapital .com ZACH BECk is thE E ditor of chilton currEnts and an opErations spEcialist at chilton capital m anagEmEnt in houston, tExas. for furthEr information on chilton capital m anagEmEnt stratEgiEs and sErvicEs, plEasE contact christophEr l. K napp, cKnapp@chiltoncapital .com for rEprints contact srinEs@chiltoncapital .com www.chiltoncapital .com/currEnts