Autos Face More Steep Downward Curves

Don't be fooled by signs seeming to point toward the bottom of the valley for carmakers.
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Now might seem like a great time to invest in auto stocks. After all, the best way to play the autos has always been to think like a contrarian. They're tremendous buys when auto sales are in the tank.

Take

Ford

(F) - Get Report

, for example. Those who bought Ford at the trough of the last cycle in 1991 could have seen a 167% gain after two years. And now signs of a bottom seem to be appearing. The stocks are down, Ford just cut its dividend, auto sales have been declining 11 out of the last 12 months, and the 0% financing deals show how desperate the automakers are to lure customers. Not only that, the stocks look cheap.

But put the brakes on that thought. We may be nowhere near the trough of this cycle. In fact, we could be just at the beginning of a long, winding, downhill ride.

Besides, relatively speaking, the stocks haven't done that badly this year. Since the market's low during the third week of September,

GM

(GM) - Get Report

, Ford and

DaimlerChrysler

(DCX)

have snapped back 14.5%, beating the

S&P 500's

13% return, while auto parts makers like

Johnson Controls

(JCI) - Get Report

,

Lear

(LEA) - Get Report

,

Visteon

(VC) - Get Report

and

Delphi

(DPH)

are up 16.7%. If we're in the midst of a classic downturn, this may be the best performance you'll get out of these stocks for quite a while.

But three key indicators give clues about when it's safe to get behind the wheel. That's the conclusion of John Casesa, the senior auto analyst at Merrill Lynch, who has analyzed previous economic cycles. The pattern he found begins with a rise in the unemployment rate, then continues with a fall of at least 10 points in the consumer confidence index as measured by either the University of Michigan or the Conference Board. The last stage is when real disposable personal income, or DPI, growth turns negative.

The Casesa chart below uses the Gulf War recession to show how each event occurred before both auto sales and the stocks themselves hit bottom. The dots labeled with the stock symbols show the point at which each stock turned up.

Auto Stocks Typically Sink With Sales Slump
The Gulf War recession

The average peak-to-trough decline in auto sales during the 1978-1982 recession and the Gulf War recession was between 20% and 30%. Casesa thinks this cycle will be no different. He's predicting sales will drop 20% from a peak of 17.4 million units in 2000 to 13.9 million units by 2003, which means the stocks could be about a year away from bottoming as well.

So far, we've had two out of the three events in Casesa's cyclical pattern. The unemployment rate first rose in March of this year. The Conference Board consumer confidence index plunged 16.4 points in September to 97.6 -- a reading that was taken mostly before the terrorist attacks. Auto sales have been declining all year. Although October sales are likely to show a big jump, ignore that figure, because it will be artificially inflated by the 0% financing deals, which automakers can't afford for long. Expect November sales to give it all back and fall sharply. As for real DPI, Casesa expects it to turn negative in another quarter or two.

Certainly the outlook for consumer income is key to the cycle now. Ken Goldstein, economist at the Conference Board, expects income growth to slow from 3% in the third quarter to 2% in the fourth quarter. "While the labor market is loosening up, that won't show up in wage gains for several quarters, because there is always a lag," says Goldstein. At this point, Goldstein doesn't see real DPI turning negative unless there's a steeper drop in consumer confidence than he anticipates. The Conference Board releases its read on October consumer attitudes next Tuesday. But Goldstein is still very cautious. He thinks the earliest that the economy could turn is second-quarter 2002, but "we have to get lucky for that to happen," he says.

In the meantime, expect grim news from the Big Three, like big losses, dividend cuts and labor fights over plant closures. Ford's preemptive dividend cut may show how bad its board expects this downturn to be. Casesa pegs break-even for the Big Three at about 15 million units, meaning they will probably start producing full-year losses in 2002 if his unit forecast of 14.6 million units for 2002 is correct. Although one might think the automakers are in better shape to cope with this cycle, Casesa says their net cash position is about the same as it was heading into the Gulf War recession, because they squandered much of their excess cash flow in recent years on acquisitions and share repurchases.

All this suggests that their stocks, while historically cheap, may stay that way for some time.

The traditional measure of valuations in a recession, although admittedly an unsophisticated one, is price-to-sales. That's because in recessions, the Big Three typically produce neither earnings nor cash flow that can be used for price-to-earnings or price-to-cash flow comparisons. Typically, stocks bottom at 15% of sales. That's about where GM and DaimlerChrysler are now. Ford is in the low 20% range, so it could still have more downside.

But using Casesa's analysis, these stocks are vulnerable until real disposable personal income turns negative and auto sales and earnings find a bottom. "The risk of being early is greater than the risk of being late, because we still have the third shoe to drop," says Casesa.

On a positive note, it may make more sense to look at the auto parts suppliers right now. More on that in my next column.

Odette Galli writes daily for TheStreet.com. In keeping with TSC's editorial policy, she doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to

Odette Galli.