Investors should focus on the long term when considering stocks they want to own. But they also can't ignore the realities of what's happening around the economy right now.
Take artificial intelligence (AI) lender Upstart (UPST 2.76%), for example. There are several reasons to like the stock as an investment over the next five years and beyond. But investors should pump the brakes and avoid buying the stock today. I'll walk you through why below.
Why Upstart could be great
I'm a fan of Upstart's long-term potential -- I own shares. The company uses AI to analyze credit risk, attempting to displace the traditional credit score as the tool that determines whether consumers are creditworthy for loans. The company makes money primarily from the fees it gets for referring successful loan applicants to its network of 100 partner banks and credit unions.
The long-term investment thesis for Upstart is simple. First, Upstart's technology has demonstrated that it works better than a traditional credit score in determining which loan applicants are worthy of receiving loans. The company provides quarterly data showing that it can better identify riskier borrowers regardless of their credit scores.
Additionally, Upstart is expanding its business beyond personal loans, which it initially built the company on. It's begun ramping up its automotive loans segment and it is now testing whether it should get into business loans and home equity lines of credit (HELOC).
If things go right, Upstart could be an AI technology powerhouse, helping consumers (and eventually businesses) borrow money faster and easier while reducing default risks for banks.
Why you shouldn't buy Upstart stock now
The FOMC has been relentlessly hiking interest rates to combat elevated inflation over the past 12-18 months. Rate hikes slow the economy down by making borrowing more expensive. The combination of outsized inflation and higher rates over the past year has worn consumers down.
Upstart tracks a handful of economic data for its Upstart Macro Index (UMI). The index is steadily rising, signaling increased default risk for Upstart's loans.
Image source: Upstart Holdings
The problem for Upstart is that banks will pull back on lending during times like this when risk is higher. Personal loans are unsecured, so consumers will stop paying those first when times are tough because they won't lose their car or home. Not only do banks realize this, but they might be especially reluctant to originate loans based on new technology (like Upstart's) versus traditional credit scores.
The lack of funding for Upstart's loans has tanked the business:
UPST Revenue (TTM) data by YCharts
In other words, Upstart loans are unnecessary risks that banks aren't as willing to take now. Upstart might not be struggling so much if it weren't so reliant on unsecured loans, but that's the reality today.
What should investors look for?
Hopefully Upstart can eventually grow non-personal loans to stabilize the business. Improving consumer financials would also help. That said, the company will probably struggle until banks are more willing to originate Upstart's loans.
What should investors look for before buying the stock? First, look for Upstart's updates on how its loans perform. You can see below that Upstart loans underwhelmed in 2021-2022 but have improved in recent quarters. Strong loan performance will be crucial to getting banks to work with Upstart more.
Image source: Upstart Holdings
Secondly, investors should keep a pulse on U.S. consumers. Upstart tracks a basket of metrics (seen in the first graphic), but you can also look in the news for updates on home and automotive defaults. If those loans default more, you can reasonably assume that personal loans are also struggling.
Don't feel like you're missing out by holding off on buying the stock. Upstart is a speculative stock that is especially risky in this economy. The company's addressable market is worth trillions of dollars, so waiting until signs of an economic rebound to invest shouldn't prevent great long-term investment returns. Patience is a virtue.
