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.

Tax Hike 2011

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.

Based on comments from last week, the party consensus among congressional Democrats on taxes seems to be eroding with some members increasingly in favor of extending the Bush tax cuts as the November elections loom.

The internal party debate increases the odds that Democrats will be unable to tackle the question of 2011 tax rates until after the November election. After the election they may choose to waive the PAYGO rules that require any tax cuts to be paid for through other tax hikes or spending cuts in order to amend tax rates in a lame duck session and avoid a 2011 tax hike back to pre-Bush levels.

The current S&P 500 price-to-earnings ratio on the next 12-month earnings expectations is around 12. This is well below the average of 15 and reflects not only the uncertainty of the transition in the global economy from recovery to sustainable growth but also the transition in spending and tax policy.

Investor Tax Rate Changes

In theory, stocks are valued by investors based on expected total return, net of applicable taxes. For example, if dividend and capital gains taxes were each set at 100%, stocks would have little value to a taxable investor.

It is reasonable to believe that the lower the tax rate, the more a taxable investor would value stocks up to that of a non-taxable investor. Looking at the post-WWII relationship between investor tax rates and stock market valuations based on trailing price-to-earnings ratios, we can see that stocks appear to have already priced in a return to much higher investor tax rates.

Based on our analysis of the tax debate in Washington we place the highest probability on the dividend and capital gains tax rates both rising to 25%. But we also acknowledge 20% or 30% rates are also potential outcomes as is a reversion to the 39.6% and 20% rates that preceded the 2003 cuts or a one year extension of all current tax rates of 15%.

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