Why the Fiscal Cliff Won’t Crush Your Portfolio

by Jason Jenkins

I don’t know if you’ve heard or not… but we’re supposedly about to fall off this fiscal cliff at the end of the year.

First the Mayans predicted the end of the world in 2012, and now it’s our own government and media yelling about doom and gloom.

This increase in taxes, coupled with government spending cuts, has the Congressional Budget Office (CBO) forecasting an expected recession in the first half of 2013. The International Monetary Fund (IMF) stated in October that if we reach the cliff, it could “at the extreme… result in a fiscal withdrawal of more than 4 percent of GDP in 2013.”

But what affect would the fiscal cliff have on the stock market? What history shows us may surprise you. Falling off the cliff may not be as devastating to your portfolio as some have predicted.

A recent study in October done by O’Shaughnessy Asset Management took a look at the historical effects of high or increasing tax rates on the market. The study looked at “historical data on tax rates, market returns, and stock selection factor criteria to evaluate the impact that income, capital gains, and dividend tax rates have had on stock portfolios.”

And what they found may surprise you…

The Fiscal Cliff and Your Portfolio

What they found is that tax rates – or changes to the tax system – have not necessarily had any meaningful bearing on stock returns. And what really doesn’t make sense is that dividend-paying stocks did their best during times of higher taxes.

Let’s look at how they came up with their results.

First, they focused their findings on the typical family earning an inflation-adjusted $250,000 a year. With a starting point of 1926, they tracked historical tax rates, long-term capital gains and dividend tax rates.

Tax Rates Versus Your Market Returns

So how has the equity market fared under different rates? After measuring the annual effective tax rate on our average family for each year since 1926, they came up with three categories – represented by a low, medium and high average tax bracket over that time period. Here’s the summary of these findings:

This information was taken from the Center for Research in Security Prices. Let the record show that when tax rates were low, so where market returns. As we see today and back in the 1930s, we’ve experienced our greatest market downturns of the last 80 to 90 years. And during this time, we have also seen the lowest tax rates over that period. The most lucrative returns occurred when tax rates were in that mid region – around 29%.

How Stocks Have Reacted to Major Changes in Tax Policy

OSAM’s study concentrated on the 10 largest one-year increases and decreases over this same 85-year period for the same typical family. Here are the numbers that summarize S&P 500 returns in the one-, three- and five-year periods right after the drastic rate changes:

What they found was that nothing is definitive. The numbers on the left side of the chart are more prevalent to us, but both sides tell the same story. History shows us that large tax increases have not been the precursor to long-term market doom.

On average, the returns for the S&P 500 in the one-, three- and five-year periods after the largest tax increases were 8.4%, 7.9% and 15.7% annualized, respectively. Those numbers fall pretty much in line with equity market expectations.

What About Large Increases in the Dividend Tax Rate

Here’s the tax history of dividend or high-yielding stocks since 1926:

  • There were 23 years where dividend income was exempt.
  • Over the last nine years they have been taxed at 15% due to the Bush-era tax cuts.
  • For 53 years dividends were taxed at the full income effective rate.

Once again, the numbers run contrary to what we may think. During times when dividend income was fully taxable, dividend stocks were 1.7% less volatile than the overall market. So there’s no historical basis for some of the most pessimistic forecasts.

To be honest, there was only one time in our market’s history when they found a huge dividend tax rate increase that could be comparable to what we may face. It happened when the Internal Revenue Code of 1954 became law. In 1954, dividends went from full exemption to fully taxable at effective tax rates. OSAM’s typical family tax on dividends went from 0% to 47% overnight.

Even with this substantial hike, dividend stocks had better returns than large stocks in the following one-, three- and five-year periods by 8.4%, 5.6% annualized and 1.2% annualized, respectively.

What OSAM Concluded

You can take a look at the entire report here.

OSAM will be the first to tell you that huge tax hikes aren’t a good thing for the market. But, the historical evidence certainly doesn’t confirm the end for equities and dividend-paying stocks for years to come.

If you look at their overall conclusion, it sounds very similar to our strategy at Investment U:

“We continue to advocate buying higher-quality stocks with attractive prices and high dividend yields.

A disciplined approach is essential when the macroeconomic and political environment is volatile and uncertain. We expect there to be volatility in equity markets as the fiscal cliff is resolved (or not) in Washington. The long-term data presented in this paper indicates that now is not a time to panic. What should ultimately drive individual stock returns is the quality of companies and the price investors pay to own them.”

Hold the fort. Be confident in your solid investment strategy.

They also went on to say “any reduction in the valuations of dividend stocks should be short term and unsustainable, and that if high-yielding stocks are sold off, the resulting higher yields and more attractive valuations will likely represent a great buying opportunity.”

That sounds more like a possible opportunity. One in which you stay in the market and keep on keeping on.

Good Investing,

Jason

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