The Market Refuses to Be Typecast

Two weeks of declines had traders thinking the holidays would be blue (or red, as in the color of declining shares on computer terminals) this year. So in keeping with its historic trait of doing the opposite of what's expected by the majority of participants, the stock market began this week with some healthy gains.

Rather than continuing recent declines, major stock proxies opened higher and were able to build on those gains as the afternoon arrived. As of 2:27 p.m. EST, the Dow Jones Industrial Average was up 1.8% to 8582.76, the S&P 500 was higher by 1.8% to 905.48 and the Nasdaq Composite was up 2.1% to 1390.59.

Factors aiding the midday advance included strong gains by European bourses. Ian Scott, head of European equity strategy at Lehman Brothers, upped his recommended weighting in U.S. equities to 50% from 39%, and Merrill Lynch added Hewlett-Packard ( HPQ) to its Focus One list. Peter Oppenheimer, European equity strategist at Goldman Sachs, also made some bullish comments about U.S. equities.

Crude prices continue to surge, which ultimately will hamper the global economy. But for now, crude's rise was giving a boost to market-cap giants such as ExxonMobil ( XOM), which was further supporting major stock proxies.

Other factors helping shares were more technical in nature, including that recent weakness in the dollar and stocks that had become overextended, both of which were due for a rebound. After trading above 104.20 earlier, the U.S. Dollar Index was lately unchanged at 103.98.

On a more emotional basis, the New York transit workers calling off (or at least postponing) the strike originally planned for midnight Monday may also be helping buoy spirits on Wall Street. New York is not the be-all, end-all of the financial markets, of course. But major equity exchanges are based in Manhattan, and concerns about a potential strike may have weighed more heavily on sentiment late last week than was generally acknowledged -- here included.

We'll have more on the broader market action after the close, but for now, a follow-up on a piece here last week about prospects for dividend tax reform.

More on Dividends

The story generated a lot of knowledgeable feedback, for which I'm always grateful. A strong undercurrent of the input from readers was that if the goal is to encourage more dividend payouts, providing tax relief to the corporations that pay dividends is more important than relief for individuals who receive the dividends (assuming tax reform is an either/or proposition).

Even if another perceived sop for big business is politically unpalatable, many contend only cutting dividend tax rates for individuals (or providing them with an exemption for a certain dollar amount) may not do much to provoke companies to increase payouts if the dividends are still taxed at the corporate rate.

Diane Garnick, global equity strategist at State Street Global Advisors in Boston, chimed in with another reason why many corporations are reluctant to pay dividends.

Under current rules, companies can only deduct up to $1 million in compensation for individual employees, noted Garnick, who gave a presentation on the subject last week at a conference sponsored by the Association of Investment Management & Research. After that first million dollars (reportedly, the toughest to make), the compensation is only deductible by the company if it is equity-linked -- i.e., based on the company's performance.

"Because of that deductibility and the opportunity to only disclose, and not expense, options, most employees get paid by options after that first $1 million," she explained, citing Bureau of Labor statistics showing 18% of all private sector U.S. employees receive some form of options payment.

In other words, it's more advantageous for companies to provide employees making over $1 million per year (read: senior management) with options rather than actual stock.

Furthermore, because their compensation is linked to options, senior management has little personal incentive to support dividend payments, Garnick observed, "because the options holder does not receive the dividend."

In a nutshell, current tax laws discourage companies from paying dividends, while current accounting rules don't require companies to record stock options as a quarterly expense. Furthermore, the prime beneficiaries from those options are the same folks making decisions about whether their firms should pay dividends, and they have little to gain personally from increasing dividends.

Little wonder, then, that the dividend yield of the S&P 500 is at such a historically low level.

"There are two structural flaws why dividends don't get paid," Garnick said. "One, there's a disincentive on the part of executives who get paid in stock options; and two, investors prefer not to have to pay ordinary income tax."

If the $1 million cap on corporate deductions is eliminated and "single taxation" of dividends also occurs, "what's likely to happen is companies will come under pressure to pay higher dividends, or start to pay them," she predicted. "What we think is going to happen is employees will start to get paid in stock vs. options." (Executive compensation truly linked with the performance of shares -- what a novel concept.)

Forcing companies to treat options as an expense against earnings is a key element to all this, Garnick acknowledged, and there is momentum behind that concept. A spokeswoman for the Financial Accounting Standards Board confirmed Monday that before the end of the year there will be a final ruling on FASB 123, which addresses changes in accounting for options.

Finally, Garnick noted that Wharton professor Jeremy Siegel has advised the White House on issues related to dividend tax reform, and has frequently opined on the same in the pages of The Wall Street Journal. He, too, was unavailable for comment Monday.

But if the professor and author of Stocks for the Long Run does return my call, I'll duly report any relevant comments.

Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to Aaron L. Task.

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