As so often happens, the conventional wisdom said to buy every day ahead of the election day because the S&P would surge and peak with the election. Conventional wisdom was wrong. Which is to be expected: in the New Normal one should take any technical signal or old trader wives tale, and do the opposite. Needless to say, the market now is unchanged from where it was two months ago, and from the day Barrons' came out with its latest top tick cover (as we said [4]"here comes that patron saint of all contrarian indicators") page praising the "Teflon Market [4]." So now that the "buy the election" meme is over and done with, what is there to look forward to for the rest of the year? According to Goldman, here comes the "sell ahead of the coming dividend and capital gains tax hike."
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From Goldman's Kostin:
Capital gains and dividend taxes have garnered less attention than other parts of the Fiscal Cliff. However, with those taxes scheduled to rise at year-end based on current law, our conversations with clients show a renewed sense of urgency as the deadline approaches.
What is the best case scenario:
Based on current law investment taxes will rise from their current 15% at year-end. The dividend tax rate would rise to 39.6%, the rate of ordinary income, and capital gains tax would rise to 20%. Each rate would also include a further 3.8% tax associated with the Affordable Care Act (ACA).
Our Washington, DC-based economist Alec Phillips believes a more likely outcome is for both capital gains and dividend taxes to rise to 20%, remain tied at the same rate, and include the ACA add-on for an all-in rate of about 24%. It is also possible those rates will be higher for upper income tax payers or that the two rates will de-couple.
We expect the capital gains tax rate to rise for upper income investors regardless of who wins the election. President Obama supports an increase in the tax rate and believes the current 15% is a historical anomaly relative to a maximum rate of 28-29% from 1987 -1996 and rates at or above the 23.8% potential 2013 rate from 1934 -1980. While investors believe Governor Romney is more likely to defend lower top rates, he has placed greater emphasis on eliminating capital gains taxes for those making $200,000 or less as part of broader tax reform.
How about worst, or in this case, realistic:
The two primary concerns of investors are that (1) the dividend tax rate could rise to 43.4% as in the President’s February budget proposal and (2) high dividend stocks carry a premium valuation that will correct if taxes rise.
Dividend taxes could alter the mix of shareholder cash return. If the tax on dividends rises to 43.4% but capital gains taxes are below 25% it could impact investor, as well as corporate, preference for dividends vs. buybacks. In October, five S&P 500 companies announced special dividends and 23 stocks raised regular dividends by an average 14%. Our Equity Research colleagues have identified companies that may pay large special dividends before year-end to avoid the potentially higher tax rates.
Which means that...
Capital gains could drive year-end tax selling based on previous history. The capital gains tax rate is scheduled to rise to 23.8% from 15% based on current law. That increase would be similar in magnitude to the 9 pp rise starting in 1970 and the 8 pp rise in 1987. In both cases the S&P 500 posted negative returns in the December prior to implementation as investors locked-in the lower rate. The market fell 1.9% in Dec-69 and 2.8% in Dec-86 running counter to trend as December has the second highest average monthly return (1.5%) and a 75% hit rate since 1928.
Bottom line is that the net cash to dividend receivers can decline by up to 33% (from 15% tax rate to up to 43.4%). The implication is that with uncertainty about the cliff and the tax treatment of dividend and capital gains still prevalent, those who are unable to take advantage of offshore tax havens (so everyone but hedge funds) will wait until the last minute then pull a reverse E-Bay and dump into the bid. Because someone will surely be there propping the bid as the torrent of selling begins and investors seek to hedge ahead of a surge in stock-related taxes. Or maybe not.
Finally, Kostin still has a 1250 year end target on the SPX.