While information on the economy, European bank stress tests, and corporate earnings helped to lift the markets last week, it may have been the hint that tax rates may not be going up as much as expected in 2011 that got investors the most excited. The potential for much higher tax rates on dividends and capital gains appears to be discounted by the market, suggesting a potential relief rally as the tax uncertainty is resolved. However, we do not expect Congress to act on taxes until after the November elections.
If we average the historical top dividend and capital gains tax rates together we find that during the post-WWII period a 25-30% combined investor tax rate was in effect only during 1991-92 and 1997-2002. During the later period, stock market valuation was at record highs well above current levels and do not serve as a good comparison due to the impact of the internet bubble distorting the overall market value. However, 1991-92 may offer a comparable period for analysis. During this period, the macroeconomic and geopolitical backdrop included the aftermath of the S&L crisis, sluggish economic growth, the first Gulf War, pessimistic consumers, and a weakening dollar. During this 1991-92 period, the average top dividend and capital gains tax rate was between 25% and 30%, and stock market valuation, measured by the price-to-earnings ratio on the next twelve months expected earnings for the S&P 500 companies, were about 15. This figure is well above the current forward price-to-earnings ratio of about 12. While there are many factors that affect stock market valuation, the potential for higher tax rates on dividends and capital gains may already be fully discounted by the market. In fact, at 12 times forward earnings, stocks appear to be pricing in a return to when the average rate was around 35% suggesting a potential relief rally as the tax uncertainty is resolved.
High Dividend Paying Stocks Underperformed when Dividend Tax Cut PassedPerformance of the Top 20% and Bottom 20% of Stocks in Russell 1000 Index by Dividend Yield
During both of the above referenced periods, U.S. and non-U.S. stocks also performed very similarly, with the world focused on Iraq. The impact of the investor tax cuts in the U.S. did not result in U.S. stock market outperformance. Also, low and non-dividend paying stocks outperformed the high-dividend payers that would benefit most from the lower dividend tax rate. It appears that the tax cuts played little or no role in stock market performance. Possible reasons may be that investors discounted the effect on future dividends since the cuts were not made permanent or that the effects on after-tax returns were deemed negligible relative to the macroeconomic and geopolitical drivers. We believe the heightened attention on taxes and the deficit is more of a concern than in prior episodes of tax rate change. Consequently, we believe a positive impact of the resolution of uncertainty around tax rates is probable given that the outcome is likely to be better than what investors have priced in to the markets. However, it is difficult to predict the magnitude. One factor that could undermine the impact of any positive action on taxes is that the changes to the dividend and capital gains tax rates may not be permanent. A one year extension of current tax rates may not be as welcome as a resolution of the tax rate uncertainty. As the year-end expiration of the 15% capital gains tax rate looms investors may be prompted to sell to lock in the 15% rate. However, there are not a lot of long-term capital gains to be taken in the stock market with the major averages still down sharply from their 2007 highs. The selling would most likely take place in sectors that have generated the largest long-term capital gains for those investors who bought stocks in the first half of 2009, such as Financials. A potential outcome of the year-end dividend rate tax hike could be a large number of public companies with a high concentration of family and closely held shares declaring and making a one-time, special dividend payment in the fourth quarter to be sure to take advantage of the 15% tax rate before it goes away.
To see why this relationship is similar for the stock market we can look at the two most important drivers of stock market return: earnings growth and valuations.