Friday, September 24, 2010


The risk of being short over the weekend is greater than the risk of being long.

On the Expiration of Tax Cuts on Dividends

So what are we to expect from the sun setting of the preferential Bush tax cut dividend rates?

I think this could have some longer-term implications but in the near term it will be quite meaningless.

Under the BTC, qualified dividend income is taxed at a maximum of 15%. One the BTC expire, there will be no difference between qualified and ordinary income tax rates on dividend. The maximum ordinary rate will skyrocket up to 40%.

We must first exclude from the analysis all non-taxable stockholders and all indexed holders from this analysis. Then of course, we have to exclude pass-through investments such as master limited partnerships, which pay dividend-like distributions but are taxed as ordinary income for the most part.

Next, let's consider the current interest rate and dividend environment. The current yield to maturity on the five-year U.S. Treasury note is 1.35% and on the 10-year U.S. Treasury note it is 2.60%. The yield on the S&P 500 index is now about 1.90%. Except for a brief period during the 2008 market decline, the yield on the SPX has been below 3% since the early 1990s.

Of course, not all stocks pay exactly the SPX dividend yield. Many pay far less or even nothing. Only a few stocks distribute far significantly greater dividend yields, such as utilities, telecom and consumer staples. The owners of those stocks tend to be income-oriented, and I would find it difficult to believe that the elimination of the BTC will compel them to sell their stocks with the yield on Treasuries at or near all-time lows.

Thus, in the short term, I do not see risks to stocks as the BTC is eliminated. The long term is another story.

In the long term, shareholders will demand higher payouts to compensate for the increased tax burden. Furthermore, the historically low interest rates in the bond market will not be sustained. Rate spreads between stock and bonds are more likely to revert to more historic levels, which can average around 3%.

When this occurs, demand will return to fixed-income securities, to the detriment of dividend-paying stocks. Growth stocks will pick up some of the slack in equity demand. Boards of directors will be weighing the benefits of increasing dividends vs. increasing share buybacks. I am going to speculate that both shareholders and boards will gravitate toward desiring increased share buybacks vs. increasing dividends. Unfortunately, too many corporate boards tend to borrow money to repurchase stock, and as interest rates increase, this could prove to be a mistake. Thus, I see some longer-term problems as the BTC on dividends expire.

There is still much too much negativity and disbelief in the stock rally.

The bond market is pulling back. For the first time in a while, bonds and stocks are trading inversely -- and that's the way it should be. I expect to see this rise in bond rates continue.

There is still much too much negativity and disbelief in the stock rally. Remember, at some point, rips won't be made to be sold -- just as we learned in 2001 and 2008 that dips were not made to be bought.

Some Perspective on Capital Gains Rates

Let's look dispassionately at what the expiration of the Bush-era tax cuts will really mean for investors.

We'll begin with the long-term capital gains tax.

Are we making too much of the expiration of the so-called Bush tax cuts, or as I shall refer to them, the BTC? Let me state without equivocation that I was in favor of those tax cuts when they were enacted and believe that they should be extended. The real questions are:

* What will be the implications of the BTC expiration in the near term?
* What will be the implications of the BTC expiration in the long term?

We have to also consider three different taxes:

* the long-term capital gains rate;
* the preferential dividend rate; and
* the estate tax (the so-called death tax).

Rather than be emotional, political or irrational, let's analyze the situations from a practical point of view for investors. Let's look at them one at a time.

Long-Term Capital Gains

1.) Let's understand that the preferential capital gains tax rate really only applies to asset held more than one year. Furthermore, the current rate on these long-term capital gains will go from 15% to 20%. Is that enough to spur selling before the end of the year? I think not. Here is the reasoning. If you have long-term status on an investment position that you intend to continue to hold, why turn back the clock on your holding period?

Say you bought 100 shares of stock more than a year ago at $100 and it is now $150. You would pay 15% tax on $5,000, or $750, to lock in the 15% rates. However, you believe the stock will go to $200. So, you repurchase the stock after you sold it to lock in the lower tax rate. Now, you could only buy 95 shares because you had to withhold some proceeds to pay the taxes. So you now own 95 shares at a cost basis of $150 a share. The stock goes to $200, as you expected, in six months. You could pay capital gains at the highest marginal tax rate of nearly 40% -- that would be $1,900 in taxes. Your original $10,000 investment after taxes would now be worth $17,100. If, however, you did not sell the stock at $150 to capture the 15% tax rate, and held it instead to $200, then you would pay taxes at a 20% rate and thus have $18,000 in your pocket. As such, terminal price targets and time horizons are far more important in determining whether you lock in 15% this year rather than waiting, opting for a 20% rate in the future.

2.) We have to exclude from the analysis all stock sales that would not be subject to tax. This would include, for example all pension plans, retirement accounts, charitable and educational endowments, and non-U.S. holders, all of whom are not subject to U.S. capital gains taxes. Then we have to figure that of those stockholders who are left, many are still toting capital loss carry forwards from the early 2000s when the tech bubble burst and from the 2008 financial meltdown. Then we need to exclude all taxable accounts that are passively managed or indexed to the S&P 500, Nasdaq, etc. We can count out hedge funds, as they could care less about long-term holding periods or capital gains rates -- hedge fund managers are paid performance fees (rightly or wrongly) on gross pretax returns.

What we are left with is a very small amount of stock that would even be eligible to take advantage of the 15% BTC. Factor in my analysis in the section above, and I conclude that in the near term, the expiration of the 15% BTC is not a market factor or game-changer come the end of this year.

3.) Looking to the long term, will a 20% long-term rate in the future deter investors from creating capital or investing in stocks? No, it will not. However, should the long-term rate be increased from 20% to, say, 40% by eliminating the benefit of long-term carrying periods, then we would be in trouble. But thankfully, that is not on the table -- it would be political suicide.

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