In recent months, the stock market managed an impressive surge. Tech stocks, especially those with a connection to artificial intelligence (AI), have led the way.
This past month saw a similar surge among numerous beaten-down stocks in the financial sector. Among these, three consumer credit stocks stood out: Capital One Financial (COF 0.16%), Ally Financial (ALLY 0.41%), and One Main Financial (OMF 0.73%). These stocks gained 27%, 13%, and 21%, respectively, in the past month.
The surge in stock prices for all these companies reflects optimism among investors. This positive sentiment can be attributed to the ongoing slowdown in inflation, as measured by the year-over-year change in the consumer price index, and a recent pause by the Federal Reserve from its aggressive interest-rate increases.
Despite the enthusiasm, I believe investors should approach these stocks, especially the three fintechs mentioned above, cautiously.
These consumer lenders serve these customers
The three stocks mentioned all share one common feature: They primarily provide loans to retail consumers. Capital One's primary business is providing consumers with credit cards using Visa's or Mastercard's payment network. It's the fourth-largest credit card issuer in the U.S., and its customer base includes many subprime borrowers or those with credit scores on the lower end of Fair Isaac's FICO spectrum. At the end of Q1, 32% of Capital One's credit card loans and 48% of its auto loans were to nonprime customers, or those with credit scores of 660 or lower.
Ally Financial's main business is providing auto loans to customers. These loans made up 61% of its loan and lease portfolio as of Q1.
Finally, One Main Financial provides and services personal loans primarily to nonprime customers. Given the customer bases for these three consumer lenders, it would be prudent for investors to consider the risks of owning these stocks in the near term.
Economists have recession concerns that could affect these lenders
The primary concern for these consumer lenders is the potential for a recession sometime this year or next. Coming into the year, 4-out-of-5 economists surveyed said they believed the U.S. could enter a recession within 24 months. Meanwhile, analysts at JPMorgan Chase said the odds of a recession before the end of this year are greater than 50%.
According to the National Bureau of Economic Research (NBER), a recession is "a significant decline in economic activity that is spread across the economy that lasts more than a few months." When determining a recession, the NBER considers things like declining gross domestic product (GDP), rising unemployment, and falling consumer spending and production.
Recessions hurt those at the lower end of the economic spectrum more, as those with lower earnings and less savings tend to feel greater pain from job losses. These individuals also tend to have lower FICO scores; this is the bread-and-butter customer base for Capital One and One Main Financial. In a recession, these companies could face higher delinquency rates than companies serving a more premium customer base, like American Express.
Meanwhile, Ally Financial's focus on automotive loans could also put it at higher risk. According to the New York Federal Reserve Bank, auto loan delinquencies are rising. Specifically, 4.6% of auto loans among borrowers under 30 are in "serious delinquency," the highest level recorded since the Great Recession.
Data source: New York Fed Consumer Credit Panel/Equifax. Chart by author.
Borrowers are facing double trouble -- higher car prices coupled with higher interest rates, which pushed up the cost of borrowing. Greg McBride, chief financial analyst at bankrate.com, told Yahoo Finance, "The average car payment for new car buyers was $800 a month last year, [and] about one-in-seven buyers has a payment of at least $1,000 a month."
Here's the bull case for these stocks
The argument in favor of Capital One, One Main Financial, and Ally Financial is that we may not end up experiencing a recession. In the Federal Reserve's most recent summary of economic projections, officials signaled they didn't believe we would see a recession by the end of the year and unemployment would rise modestly from 3.7% to 4.1%.
If the Fed can engineer a soft landing that brings down inflation without affecting the unemployment rate materially, then buying these stocks today makes sense because they benefit during periods of economic expansion. However, if you believe a recession is inevitable and unemployment rates rise significantly, these companies would be among the first to feel the pain because of their customer bases.
Final thoughts
Capital One, One Main Financial, and Ally Financial have run up their valuations quite a bit in the past month, and those valuations aren't that discounted from their 10-year average price-to-tangible book values.
ALLY Price to Tangible Book Value data by YCharts.
While we can't predict if and when a recession will happen, we can weigh the potential risks and rewards of owning these stocks at today's prices. Given their run-ups and not-so-discounted valuations, I'm avoiding these consumer lending stocks for now. If we experience a recession that brings down the valuation of these companies, it could be an excellent time to buy the dip and ride these stocks through the subsequent economic recovery.
