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Posted on 10/14/2003 1:25:07 PM PDT by Sam Cree
The dividend and cap gains tax cuts are nice to have. But they just don't make up for the depressed earnings yields and dividend yields on stocks. More From A. Gary Shilling
Does the new tax law make the current rally rational? It would be nice to think so. Signed into law by President George W. Bush on May 28, the legislation reduced the top rates on both dividends and capital gains to 15%. Before, we were paying 38.6% on dividends and 20% on cap gains. That's a nice benefit for investors, but the unfortunate truth is that it falls far short of justifying today's steep prices on common stocks.
Stocks are very expensive. The average one (measured by the weighted S&P 500 index) goes for 29 times the last 12 months' earnings. That ratio is twice the postwar average. The dividend yield of 1.7%, albeit up from the 1.1% low in August 2000, is dismally low by historical measures, at less than half the postwar average.
Strictly on chronology, you could make a case that the current rally is a response to the tax cut: While most of the 25% gain in the S&P 500 since its Mar. 11 low came before Bush signed the law, the market's normal behavior is to anticipate good news. But that doesn't mean that the rally was rational.
Let's say you have a $29 stock that earns $1 per share. Assuming you get your hands on those earnings through some combination of dividends and share appreciation, and that you realize your gains right away, you earn an aftertax 85 cents a share at a 15% tax rate. That's better than what you would have without the tax cut, but it's short of terrific. The 20th century's average earnings on $29 of common stock was more like $2. Even with a stiff 40% tax, that is an aftertax $1.20.
Focus, if you prefer, on the dividend. The current yield of 1.7% is 1.5% after federal tax. That's low. At the long-run average yield of 3.6%, even with 40% tax, you'd have 2.2%.
A useful exercise is to compare the current situation with the last time inflation was very low, the early 1960s. (Inflation was 1.2% annually then; over the past year it has been 2.2%, but I expect it to go lower.) In the early 1960s shareholders made out appreciably better with both capital gains and dividends, even though taxes were somewhat higher. The key difference was that, four decades ago, stocks were much cheaper. The S&P 500 P/E averaged 18 and the dividend yield was 3.2%.
Statisticians at my firm had to make some adjustments when comparing the 1962-64 period with today. The top tax bracket was 91%, yet that applied only on incomes over $400,000, a sum that was 56 times the median income. With the tax dodges available then, few of even the wealthiest taxpayers paid a 91% tax ondividends.
So to see the effect of taxes, inflation and stock prices, we used a hypothetical investor whose income is twice the median, a level that today would apply to a family of four making $130,000. In the early 1960s the marginal rate for that group was 22% on dividends and 25% on capital gains. And we further factored in state taxes, picking New York as typical of big states with income levies.
After both federal and New York taxes, the dividend yield is now 1.3%. That's better than the 1% last year before the tax rate drop, but not much, because it starts out so small. In comparison, the aftertax yield on stocks averaged 2.1% in the 1962-64 years.
What about capital gains? In the early 1960s stock appreciation averaged 7.5% annually. Now subtract taxes, which weren't quite as bad as the posted 25% rate because taxable gains were only 2.5% of total market capitalization--a reflection of the fact that equities are often either held in tax-exempt accounts or left in strongboxes for years at a time. Now subtract inflation. The real, aftertax appreciation on stocks was 5.4% in the early 1960s. The comparable figure today, assuming the same 7.5% annual price gain, would be only 4.8%.
Now calculate a real aftertax total return, the sum of the returns on dividends and capital gains. Today's number is 6.1%, below the 7.5% of the 1962-64 years. The new 15% tax rates simply don't offset the much higher P/Es and much lower dividend yields that now prevail.
What if, as I have been predicting, we enter a period of mild deflation? It's plausible that with good deflation of about 1.5%, nominal stock appreciation will run about 1% annually, as spelled out in my June 23 column. I also assume dividend yields will bounce back to 3%. After taxes and deflation, this all works out to a 4.8% real aftertax total return. That's better than the negative returns witnessed in the inflationary, high-tax 1970s. And deflation's salutary effect on real returns isn't taxed. But it's certainly not a reason to take out a home equity loan to go into the stock market now.
We all love lower tax rates. Still, they don't justify the current prices on stocks. Or make up for stingy dividends.
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FreeRepublic , LLC PO BOX 9771 FRESNO, CA 93794
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It is in the breaking news sidebar! |
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How about not taxing income?
You get a second here; let's put it up for vote =o)
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