Ally Financial Tumbles: Investors Should Adjust Their Near-Term Expectations (NYSE:ALLY)

Ally Financial Inc. (NYSE:ALLY) stock just fell by nearly 20% on the day after the CFO’s remarks on the weakening U.S. consumer as it struggles with high inflation, higher interest payments and most recently – a weakening job market.

Although these risks were relatively easy to predict, the market seemed rather surprised on the recent announcement. Thus, the stock is now already in negative territory on a year-to-date basis as investors begin to price-in deterioration of the U.S. consumer.

The reason why I say that this risk was easy to predict is because back in April of this year, I warned about ALLY’s limited upside through the rest of the year on the back of fading macroeconomic tailwinds and the stock’s premium valuation.

A few months later, ALLY reported its Q2 2024 results and the market was not impressed. The stock peaked right before the earnings release as the management raised the alarm on worsening market conditions.

Ally Financial (NYSE:ALLY) stock dipped 2.0% in Wednesday premarket trading as the auto lender boosted its expectations for losses from bad debt in 2024.

Source: Seeking Alpha

After the sharp fall yesterday, however, many investors might be tempted to buy as the market tends to overreact on news and speculations regarding the economy. Unfortunately, however, things are not as straightforward as they might seem on the surface.

A Mixed Picture

The sharp fall we saw yesterday was certainly a wake-up call that something was amiss. It showed that investors were perhaps too optimistic about Ally’s near-term prospects.

As a starting point, the near 20% drop appears to have been a much-needed correction as Ally’s current price to book ratio of 0.86 is right on the trend-line plotted between the stock’s quarterly return on tangible equity (ROTCE) and the market premium on common equity.

As we could see on the graph above, as of the end of Q1 2024 the price to book ratio stood above 1 which was assuming ROTCE to reach values of around 30%. Such high levels would require not only normalization of credit conditions, but also a very robust economy and auto-market. In my view, this is a possibility, but also a scenario with very low probability at the moment.

The Positives

On one hand, we do have the yield curve gradually normalizing and the 10-year 2-year one is already un-inverted which is a positive sign for Ally’s profitability.

I covered all that in further detail back in January of this year, but in a nutshell, Ally’s interest paid on deposit has become a burden even though yield on loans has stayed elevated.

That is why we have the company’s net interest margin staying flat over the past 12-month period, even as more new loans are originated and very high yields.

During the last quarter, Ally’s management slightly elevated its 2024 guidance, with net interest margin expected to be at around 3.5% at the end of the period.

Therefore, as long as a recession is avoided it seems highly likely that Ally Financial’s net interest margin and consequently ROTCE have bottomed already during the first quarter of 2024.

Based on all that it seems reasonable that ALLY has further potential for upward multiple repricing going forward.

The Negatives

The problem with the optimistic scenario we see above is that we cannot look at rates normalizing in isolation. The sole fact that the yield curve has un-inverted points to the risk of a recession in which case the high-yielding auto loans would be severely hit.

Changes to The Conference Board Leading Economic Index® (LEI) suggest that the risk a recession is real and as rates continue to normalize the U.S. consumer is likely to be squeezed. In such a scenario, delinquencies in auto loans are among the first ones to soar.

Although we are not in a recession yet, Ally Financial’s provisions for credit losses are already at a record high relative to the company’s net financing revenue. That is why the recent indication by the CFO at the Barclays Global Financial Services Conference that credit conditions are worsening was not well-received by the market and is pointing to more troubles ahead if we enter into a recession.

The other side of the picture is that as short-term rates fall (which is to be expected in a recession), Ally Financial is faced with a near-term pressure due to its significant floating-rate exposure on its asset side. In the medium term, it is overwhelmed by the liability sensitivity of the company’s balance sheet. This dynamic is obviously problematic for the short-term oriented markets and as we saw earlier this week could lead to preemptive selling by market participants.

Investor Takeaway

The recent remarks by Ally Financial CFO at the Barclays Global Financial Services Conference have spooked investors by the prospects of worsening health of the U.S. consumer and near-term headwinds stemming from rate cuts. Investors should be prepared for more pain ahead, especially if they have an economic slowdown as their base case scenario for the next 12-month period.

Beyond these near-term pressures, however, ALLY appears well-positioned to weather the storm and stock is currently priced more in-line with its business fundamentals. Having said that, I expect more volatility ahead, which will most likely result in better entry points for investors. That is why I retain my hold rating on the stock and do not see a reason to panic based on the currently available information.