(By Mani) A resolution to the so-called "fiscal cliff" is anyone's guess at the moment, but what is clear is that the prospect of higher taxes has clearly spooked investors. In fact, the S&P 500 has shed close to 5 percent since Election Day.
President Barack Obama and Republicans are negotiating "fiscal cliff," which is nothing, but a budget and tax deal to avoid tax increases and automatic spending cuts.
"While we will leave it to the experts to discuss the specifics of potential fiscal cliff outcomes, we are certain that any eventual deal will require a balanced approach of spending cuts and revenue increases in order to effectively put our fiscal house back in order," BMO Capital Markets Chief Investment Strategist Brian Belski wrote in a note to clients.
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For instance, government spending as a percentage of GDP has skyrocketed over the past several years while tax receipts have plummeted. Thus, it is not a stretch to suggest that both will need to return closer to historical norms to make meaningful strides with deficit reduction.
So what does the prospect of higher taxes mean for the markets?
Despite the common perception, historical evidence suggests that tax policy generally does not affect market returns. In fact, the lowest and most volatile average annual returns for the S&P 500 have come during years with the lowest average tax rates.
"According to our analysis, tax policy has not had a meaningful impact on market returns throughout history even for dividend paying stocks. Instead, it is the business cycle that ultimately determines stock market direction and current trends appear to support further momentum, in our view," Belski said.
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On the other hand, years where top marginal tax rates were significantly higher have produced the most favorable risk and return characteristics for the market. The rationale is quite simple – market performance is ultimately determined by the economic cycle, not policy and economic growth has typically been stronger during years where taxes were higher.
Although, changes in tax policy have not occurred too frequently throughout history, particularly tax hikes. In fact, over the past 100 years taxes have been increased just 17 times and just seven times during the post Word War II period.
"According to our work, average market returns are quite strong in the years immediately following tax hikes," the analyst said.
For instance, the S&P 500 has returned roughly 18 percent during the first year of a tax hike, on average, and was able to maintain high levels of return for up to five years following the initial tax hike. By contrast, market performance has been well below historical norms in the years immediately following tax cuts. Again, this is because the economy happened to be weaker in those years, not because of tax policy.
Meanwhile, much of the worry surrounding tax hikes and potential market impact has centered on dividend stocks, given the strategy's prominence over the past few years.
"Our analysis similarly suggests that higher levels of tax rates are not necessarily a performance impediment for dividend stocks. Like the overall market, dividend stocks have generally exhibited better average annual returns during years with higher tax rates," Belski noted.
The one caveat is that dividend stocks have produced their lowest average annual returns during years of exceedingly high tax rates. However, the average return is still nearly 10 percent, a far cry from the impending doom that some suggest for this group, given the prospect of higher tax rates.
In addition, returns for dividend stocks in the years immediately following a change in tax rates are quite similar regardless of the direction of the change. Lastly, despite some arguments to the contrary, tax rates have also had little impact on the growth rates in dividend payments, which has shown better growth rates in the years immediately following tax hikes.
"Given that payout ratios remain historically low while corporate cash levels remain historically high, we would expect current dividend growth trends to continue regardless of the tax environment, particularly considering our own more muted earnings growth outlook for 2013," Belski noted.
Consequently, the business cycle determines stock market direction, not taxes. Fortunately, the market is seeing some tailwinds in important parts of the economy lately that are likely to persist unless our government does the unthinkable and allows us to go over the fiscal cliff – which as of now is a low probability outcome.
'We continue to believe that many investors are underestimating
US economic growth prospects in 2013. For our part, we believe US growth will
end up somewhere between 2.5% to 3% next year, driven mainly by a rebound in
capital expenditures but also improvement in personal consumption," Belski