There's No Deflation in This Market

It's a personal-finance axiom that buying nice used cars instead of new ones makes good financial sense. Historically, cars have depreciated most dramatically in their first few years of life. Many two- or three-year-old cars are nearly new mechanically, but they sell for thousands less than comparable new models. These vehicles have long represented the "sweet spot" of the auto market.

Unfortunately, that sweet spot has been turning sour. According to industry-watchers Edmunds.com, used car prices are way, way up. The average price of a three-year-old vehicle in July had risen a whopping 10.3% year over year.

Given all the recent talk of deflation, that's kind of a surprising statistic. But is it an economic indicator, or something else? What's really going on?

Supply and demand, examined
Rising prices suggest one of two things: Supply is down, or demand is up. And the supply of used cars is in fact down, for a couple of reasons:

  • "Cash for Clunkers." Last year's $3 billion program to get folks to trade in old cars on new ones turned out to be popular -- and the "clunkers" provision of the program required the destruction of the whopping 690,000 cars that got traded in, even if they were fairly new and nice. AutoNation (NYSE: AN  ) alone sent 10,000 to the scrapyard.
  • Remember the economic Armageddon? Folks weren't buying many vehicles during the worst of the economic crisis in 2008 and early 2009. What's more, the automakers all but abandoned leasing during that period, meaning there's a shortage of the just-returned leased vehicles that have historically made up a big proportion of the "nearly new" used-car market.

But demand is up, too, which leads us to another revealing statistic. A widely watched metric of U.S. auto sales currently predicts that this year's new-vehicle sales will total 11.1 million units, down sharply from 16.14 million in 2007.

2007 wasn't abnormally high, either -- in fact, it was considered a down year at the time, the lowest since 1998. And the automakers aren't convinced the market will recover any time soon. One key to Ford's (NYSE: F  ) much-vaunted turnaround has been the company's ability to generate a profit at a lower level of sales than before, a point that hasn't been lost on restructuring rival General Motors.

Even though new-vehicle sales are down, people still need to buy cars. But consumers are still being more careful with their money -- and that includes buying used. That, in turn, is making for a crazy market.

It's more insane than you think
How crazy? According to Edmunds.com, some year-old used models are actually selling for more than their brand-new counterparts, when all costs are taken into account. Now, their analysis includes some assumptions that won't apply to everyone -- for instance, they assume that both the new and used car will be financed, and that the used-car buyer will pay a higher rate of interest -- but the essential point is valid. Prices have gone nuts, and all levels of the used-car market are feeling this pressure.

From the perspective of car dealers, this is both good and bad. On the one hand, used-car sales can be quite profitable for dealers, especially via the "certified pre-owned" programs pushed by manufacturers Toyota (NYSE: TM  ) and Honda (NYSE: HMC  ) in recent years. On the other hand, some reports suggest that dealers are feeling the supply pinch. The Detroit News reported that some dealers are even turning to eBay and Craigslist to find enough cars to meet demand -- which will drive prices up even further over time.

Another problem for dealers: Financing these suddenly pricier cars. The Detroit News reported that some lenders have been slow to recognize the current market's realities, and dealers have lost sales when would-be buyers find that they can't get financing at current prices.

How to take advantage
As with any seeming market distortion, it's worth asking whether there are ways for us to take advantage. One idea that comes to mind is auto-parts retailers: If people are buying used, can we assume that they'll keep their cars for a longer time, which will in turn push sales at companies like AutoZone (NYSE: AZO  ) and O'Reilly Automotive (Nasdaq: ORLY  ) ?

I don't think it's that simple, in part because it's not clear whether this is a blip or a longer-term trend. I do think that if you've been considering trading in your still-nice car for something new, this might be a good time. But I think it might be an even better time to sell that car on your own -- with demand way up, and even the dealers prowling eBay, your car might be more popular (and more valuable) than you think.

Speaking of deflation, Morgan Housel knows why you can't sell your home.

Fool contributor John Rosevear recently bought a nearly new used car, and he's quite happy with it. He owns shares of Ford, which, like eBay, is a Motley Fool Stock Advisor recommendation. Motley Fool Options has recommended a bull call spread position on eBay. You can kick the tires and test-drive any of our Foolish newsletter services free for 30 days, with no obligation. The Fool's disclosure policy loves the smell of exhaust fumes in the morning.


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