How A Capital Gains Tax Hike Could Affect The Market
Stocks sold off last Thursday after reports indicated the White House was proposing increasing capital gains taxes. As investors, this is a story we can’t ignore — even if it’s not one that affects us personally.
The proposal emphasizes that the highest tax rate will only apply to the very richest families. I saw a report that just 0.3% of the wealthiest families would be affected. And while that sounds like a small number, there are nearly 121 million households in the United States; that means more than 36,000 households would be subjected to these tax increases.
The households located in high-tax states could face rates of more than 50%. This would obviously affect their decision making. And that’s why it may matter for the rest of us…
Risk Vs. Reward
Let’s say one of these wealthy families is considering where to invest $1 million under a high-rate regime. Their adviser tells them they can expect a return of 7%-10% in the stock market. Assuming a 10% return, that $1 million will grow to more than $2.5 million in 10 years.
Selling at that point will trigger a 50% tax, for this example. The gain of about $1.5 million results in a tax of about $750,000. Not bad, the $1 million is now $1.75 million after taxes.
But inflation has reduced the buying power of that money over 10 years. Assuming we hit the Federal Reserve’s optimistic target of inflation of just 2% a year, the $1.75 million fortune will only be able to buy as much as $1.4 million in today’s dollars. That’s an effective return of 40% after taxes and inflation. Annualized, that’s a 3.4% return on investment.
And that’s under the best-case scenario. There are risks. Stock prices could fall. Or they could deliver less than 10%. Inflation could rise. The returns could be lower, or higher.
Many wealthy families will realize that returns could be lower and that they can obtain similar or better returns in something like safe, tax-free municipal bonds. Or they might invest in other assets where gains can be sheltered. They may also consider strategies to avoid capital gains taxes, maybe by donating appreciated securities to charity.
Bringing It All Together
Please note this is not tax advice. And I’m not interested in debating the merits of the policy itself. I am just thinking through the implications of the policy proposal for the market and for investors.
The point is higher capital gains taxes will almost certainly affect capital allocation decisions. We can reasonably predict some of them, while others may not be quite as obvious. For example, if municipal bonds become more attractive, I’d expect local governments to issue more to take advantage of the increased supply. This will lead to less efficient allocation of capital compared to aggressive growth investments.
That’s the bottom line – higher rates could drive capital to less growth-oriented investments. That could lower the future rate of return on stocks, and that affects us. This is a long-term concern, of course, but it only adds to my worries about the long run. It’s also one of the reasons I’m continuing to focus on the short run with my trading.
How I’m Trading Right Now
For example, over at Maximum Income, we initiated a trade in PPG Industries, Inc. (NYSE: PPG).
PPG is a specialty chemical maker. The company’s products touch many parts of our lives. Its coatings are found on airplane parts, kitchenware, and drivers’ licenses. These are the kind of products that are relatively immune to recession.
The company’s cash flow from operations increased in 2020 compared to 2019, a sign of the product line’s resilience. Earnings have been relatively stable, and growth is expected to accelerate in the next few years.
While this is a stock that could be attractive to long-term investors, the qualities that make it appealing are the reasons it offers little risk in the short run. There is unlikely to be bad news from a company with a product like this, and the stable operations also lower risks.
Adding to the safety is the “buy” signal shown by my Income Trader Volatility (ITV) indicator, shown in the bottom panel of the chart below.
While buy-and-hold investors may do well with PPG at this point, a short-term trade offers significant income potential and is a better plan in my view. This time-tested strategy that allows me and my readers to get paid with immediate income — while still collecting the dividend for as long as we hold.
Think of it as like an “insurance” policy — it protects us, while still giving us the chance to profit. And if everything works out, we’ll generate far more income than the average “buy-and-hold” investor.