U.S. vehicle sales declined in 2017 for the first time since the financial crisis. The first two months of 2018 were also unimpressive for the auto sector, but the growth trend came back in March, with the major automakers registering strong sales. A robust job market and favorable tax laws have worked in favor of sales. Moreover, rising demand for profitable crossovers, sports utility vehicles (SUVs) and pickups are also aiding the auto industry.

However, the auto space has also grappled with several challenges. Trade tensions between China and the United States, the compulsion to embrace various changes, and safety recall issues are some of the challenges faced by the automakers.

Also, the industry is going through a transition. The necessity of manufacturing electric vehicles in a profitable way is fast becoming a big challenge for automakers. In recent times, General Motors Company (GM - Free Report) and Ford Motor Company (F - Free Report) have added some new EVs to their individual lineup. German auto major, Volkswagen AG (VLKAY - Free Report) is also committed to introduce new energy vehicles. Other automakers are also following suit.

These challenges are showing up in the sector’s stock market performance. Stocks in the Zacks Auto sector are down -2.6% in the year-to-date period, lagging the S&P 500 index’s +0.4% gain. On a trailing 12-month basis, the sector’s performance is roughly in-line with the S&P 500 index.

Zacks Industry Rank – Positive Outlook

The typical characteristics of the auto industry prompted us to have a dedicated sector for the industry in our database. The automobile sector is one of the 16 Zacks sectors, unlike the S&P classification, wherein autos is part of the Consumer Discretionary sector. The S&P has 10 sectors compared with the 16 sectors for Zacks.

At the expanded classification level, the Zacks Auto sector is divided into six industries: Auto-Domestic, Auto-Foreign, Auto-Original Equipment, Auto-Replacement Parts, Auto-Internal Combustion Engines and Rubber-Tires. The level of sensitivity and exposure to the different stages of the economic cycle vary for each industry.

We rank over 250 industries in the 16 Zacks sectors, based on the earnings outlook and fundamental strength of the constituent companies in each industry. We put our industries into two groups — the top half (industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank). Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. 

The current Zacks Industry Rank is 116 for Automotive-Domestic (placing it at the top 45% of the 250 plus Zacks classified industries), 83 for Automotive-Foreign (placing it at the top 32% of the 250 plus Zacks classified industries), 88 for Automotive-Original Equipment (placing it at the top 34% of the 250 plus Zacks classified industries), 63 for Automotive-Replacement Parts (placing it at the top 25% of the 250 plus Zacks classified industries), 4 for Automotive-Internal Combustion Engines (placing it at the top 2% of the 250 plus Zacks classified industries), 116 for Rubber-Tires (placing it at the top 45% of the 250 plus Zacks classified industries).

Looking at the exact location of these industries, one could say that the general outlook for the auto industry is Positive.

Sector-Level Earnings Trend

The auto sector contributed 1.6% to the total S&P 500 earnings in 2017. This is nearly double its 0.8% market-cap weight in the index.

Looking at the fourth-quarter 2017 results of the auto sector, earnings advanced 20.3%. Auto sector earnings are expected to rise 4.3% in the first quarter of 2018 and 19.4% in second-quarter 2018.

Total revenues rose 30.2% year over year in fourth-quarter 2017. Revenues are expected to rise 24.3% in the first quarter of 2018 and 7% in second-quarter 2018. 

Earnings for 2018 are expected to decline 3.7% from 2017. Also, revenues for the year are expected to decrease 0.9%. Again, earnings for 2019 are expected to rise 0.2%, and revenues are projected to rise 0.5%.

Bottom Line

The auto sector currently has ample opportunities amid serious challenges. While a strong economy, robust demand for SUVs, attractive financing options and impressive vehicle launches are driving sales, rising auto loan defaults and high levels of safety recalls are acting as dampeners.

At this juncture, we recommend stocks such as PACCAR Inc. (PCAR - Free Report), Allison Transmission Holdings, Inc. (ALSN - Free Report) and Honda Motor Co., Ltd. (HMC - Free Report), each carrying a Zacks Rank #2 (Buy).

PACCAR has an expected long-term growth rate of 9.8%. In the past year, shares of the company have gained 2.1%.

Allison Transmission has an expected long-term growth rate of 10%. In a year, shares of the company have returned 12.7%.

Honda has an expected long-term growth rate of 4.8%. In a year’s time, shares of the company have returned 18.6%.