2002 just missed being a Bear Super Bowl — a year in which the stock market drops 25 percent. Yet the odds must still remain that 2003 or 2004 will produce such a Bear triumph, the first since 1974, when the Bears won by a drop of 29.72 percent on the Standard and Poor’s 500 Index and 27.57 percent on the Dow Jones industrial average.
The rare nature of such a triumph makes it appear unlikely. Yet a Bear “trifecta” — three losing years in succession for the markets — such as we had in 2000-2002 appeared equally unlikely a year ago, not having happened since 1939-41. This time, interestingly, the third down year was by far the most savage of the three, with the S&P 500 Index dropping by more than 23 percent in 2002 compared with 13.05 percent in 2001 and 10.14 percent in 2000.
A fourth Bear year is even more unlikely at first sight. Since the Dow Jones index was initiated in 1896 a Bear four-peat has only happened once, of course in 1929-32. Interestingly, another reminiscence of that infamous period came Thursday, when the Dow Jones index rose by its third greatest year-opening day’s gain on record. The second greatest? — 1931, a year in which the Dow dropped a dizzying 52.67 percent.
Market optimism has of course been enhanced by leaks of President George W. Bush’s $600 billion stimulus package, expected to be announced in Chicago on Tuesday. At first sight, this should be beneficial to the economy in general, and the stock market in particular — it does after all purport to abolish the double taxation of dividends, which I had suggested should be the first priority of a president seeking to be re-elected in 2004.
The double tax abolition, however (if indeed the president does indeed propose its abolition, and not merely its reduction by 50 percent, or the institution of a modest tax exemption for retail savers) seems likely to be done in the wrong way. If current reports are correct, the abolition will address only individual taxpaying holders of shares, removing their tax liability on dividend income. If so, it will ignore individual holders who hold their shares in Individual Retirement Accounts or other non-taxable forms, as well as institutional, corporate and foreign holders (some of which are taxpaying, some not.)
By focusing tax relief on holders of a minority of shares, the proposed relief misses out on the most important benefits of full double tax relief, in which dividends paid by a company are deductible against its corporate income for tax purposes.
First, stock valuation. As I have written many times, and have now been joined by many others, the stock market remains heavily overvalued by historical norms. Double tax relief at the corporate level would address this problem directly.
As Bush will have learned in his first year at Harvard Business School finance class, if he was paying attention, the value of a common stock is the current value of the dividends that can be expected to be received on that stock, from now until the company is liquidated. No amount of Internet flim-flam in the 1990s changed that; the value of any investment is simply the current value of the cash flows the investor can expect to receive.
During the bubble period, many sloppy analysts modified this formula to read “current value of all EARNINGS on the stock” — thus raising the apparent value of the S&P 500 Index nearly threefold — but this is of course a fallacy. Investors never actually get any benefit from earnings, which are merely figures produced by company management and the accountants to make the stock price go up. Only when the money is disgorged from management’s sticky fingers do investors receive a tangible benefit.
Removing the corporate tax on dividends would have immense benefits. It would remove any excuse for management to hang on unnecessarily to investors’ money. By increasing dividend payout rates (the percentage of earnings paid out as dividends)and thereby dividend yields, it would stabilize the stock market and reduce the scope for accounting shenanigans in company earnings statements.
As important for the economy as a whole, and a huge benefit for Uncle Sam, it would cause strong investor opposition to corporate tax shelter investments, since the corporation would be able to shelter taxes equally well by paying the money out to investors.
Assuming that management paid out to shareholders the cash flow benefit of the tax exemption, dividends paid would increase by 35/65 (53.8 percent) and the equilibrium value of the stock market would increase correspondingly, from around 5,000 to around 7,690, much closer to its current level. There would still be a possibility of a further downward lurch, but the underpinnings to the market would be much stronger.
The leaked Bush proposal does not have these advantages. For one thing, for most investors, it does not remove the disproportion between dividends and capital gains in their taxation. Currently, for a top bracket individual taxpayer, dividends are taxed at a total of 60 percent (35 percent corporate, compounded by 38.5 percent individual, ignoring state taxes) while capital gains are taxed at 20 percent. The leaked Bush proposal reduces this distortion for such an investor, to leave dividends taxed at 35 percent and capital gains at 20 percent.
However, for an individual investing through his IRA or 401(k) plan, for a pension fund or for a foreign investor, the distortion remains. Dividends remain taxed at the 35 percent corporate tax rate, while capital gains are tax free. Nothing has changed.
Since individuals investing directly hold far less than 50 percent of the shares of most companies, there will be little change in corporate behavior as a result of this change, since any individual move to increase dividend payouts will be opposed by pension funds and other investors for whom dividends are still tax-disadvantaged (as well as by self-serving management with stock options.)
Further, while a minority of stocks such as tobacco companies and utilities that pay high dividends will see a surge of individual investor buying, the great majority of stocks will see no significant effect — if dividend payouts are not to increase, then tax free status for a minority of investors on a S&P 500 Index yielding (currently) 1.7 percent is just not enough to matter. Consequently, although the stock market may see a run-up caused by recognition of the dividend problem, as well as by anticipation of the simple Keynesian effect of the stimulus, there will be no significant long term valuation effect.
Protecting stock option holding management from high dividend payouts, while missing out on almost all the stock market benefits of full tax relief is of course to be expected from an administration whose treasury secretaries were respectively chairman of an aluminum company and CEO of a railroad. Whatever their other merits, Paul O’Neill and John Snow do not have the intuitive grasp of domestic and international financial markets that a treasury secretary requires. From their backgrounds, they would both be much more suited to the post of secretary of commerce — in the William McKinley administration (1897-1901)!
The proposed stimulus package is likely to have another negative effect on the economy, which will also make itself felt through the financial markets. As I forecast in mid-2001, the federal budget deficit for 2002 came in at close to $200 billion. While most pundits are forecasting a $200 billion deficit in fiscal year 2003, ending next September, I have already forecast $300 billion, based simply on a continuation of current policies and a weakish economy. The Bush stimulus package of $600 billion over 10 years, except the dividend tax cut, seems likely to be heavily front-loaded, probably at least $100 billion each in fiscal years 2003 and 2004. The Iraq war, if it happens, will add a further $50 billion to $100 billion to the deficit in fiscal 2003.
Nothing we have seen so far from the Hastert congresses (the 107th or the 108th, which convenes Tuesday) or from the administration suggests any capability to restrain spending on domestic goodies. In particular, a likely prescription drugs benefit for seniors will add maybe a further $50 billion per annum to the deficit.
It is thus likely that the fiscal 2003 deficit will come in at $400 billion or so, while that for 2004 will be somewhat higher, maybe approaching $500 billion.
It irks me to admit it, but at some level former Treasury Secretary Robert Rubin, an investment banker, was right; a deficit at that level, representing 4 percent to 5 percent of gross domestic product is likely to have an upward effect on interest rates. The Federal Reserve Board has lowered short-term rates almost as far as it can, to 1.25 percent, so it is thus likely that long-term rates, currently just over 4 percent for 10-year Treasury bonds, will rise, maybe to 5 percent for the same securities.
For the corporate sector, this does not matter much. Much of the corporate sector is in any case busy recovering from the over-borrowing of the 1990s, so is much more likely to be affected by an improvement or deterioration in its own credit rating than by a 1 percent move in long-term bond rates.
The housing sector, however, has been the prop of the economy during 2002, both because of new home purchases and because of cash injections to the economy from refinancing existing mortgages.
A 1 percent upward move in long-term interest rates, raising mortgage rates from their current 6 percent for prime 30-year mortgages to 7 percent or so, will have a chilling effect on this market. It will stop refinancing more or less dead in its tracks, and will slow considerably the appetite for new expensive homes. Needless to say, this will produce a negative wealth effect on the consumer which, for almost everybody, will far exceed the positive effect of tax relief on the 2 percent dividend yield on their equity holdings.
As I wrote a couple of weeks ago, there are a number of reasons to expect consumer spending to drop sharply in 2003; a budget deficit going forward of $400 billion to $500 billion certainly adds a big new one. Whatever the tax stimulus Bush provides, it will be another very difficult year.
Without the boost to stock valuations that would be provided by dividend tax relief at the corporate level, the outlook remains for a drop in stock prices to their equilibrium valuations, say 5,000 on the Dow Jones industrial average (a 40 percent drop) or 600 on the S&P 500 Index (a 32 percent drop.) Not to speak, of course, of the possibility of the market overshooting on the downside once equilibrium has been reached.
If the Bears are unlucky, this will take place evenly over the two years 2003 and 2004, and they will miss out on their Super Bowl. But that’s not the way I’d place my bet!
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.