• Angus Crennan

Can taxes kill a bull market?

Taxes are significant

Yes, tax changes can kill a bull market.

Taxes are certain while investment gains are not. Taxes are also significant – 30% of anything is going to be missed. Because of their significance and their certainty taxes can change financial decisions which in turn can ultimately cascade into significantly changed market sentiment.

Why are we talking about taxes? The US is substantially increasing capital gains tax on investors

US President Bident has announced sweeping changes to the US Government’s involvement in the US economy. The proposed legislation would significantly increase government involvement in the energy and education sectors for example. To fund those increased expenditures substantially increased capital gains taxes on Americans earning $1m or more, nearly doubling capital gains tax from 20% to 39.6%, have been proposed.

On balance this will result in more investors realizing their gains before taxes change

Lets try to put ourselves in the shoes of two hypothetical wealthy American families and guess what we would do with this proposed change.

Family A – long term investors: Family A are still 10 years out from retirement and so plans on holding their investments for at least a decade yet. For this reason the capital gains taxes they ultimately end up paying cannot yet be known, and the expected returns they make over those future years are expected to be very attractive. So Family A hears of this proposed tax but initially it does not catalyse a change in their plans.

Family B – short term investors: Family B are a couple late in life who are already giving some thought to their legacy in the form of educating their grandchildren. Family B are sitting on $10m in unrealised capital gains having been invested in some good companies for many decades. Because they expect their wealth will need to be distributed at some point in the not too distant future learning of a doubling in the capital gains tax they will pay, from 20% to 39.6%, immediately incentivizes them to bring forward realisation of those gains by selling out now and so save nearly $2m in additional tax.

More (big) sellers generally means share prices fall

So now we have one investor who will do nothing new and another who wants to sell a block of shares. On balance there are now more sellers than there were before. What happens in an orderly market where selling pressure increases without corresponding increase in buyers? Share prices fall.

Now the rest of the market knows increased taxes are on the cards, and they too start to scenario this out, and come to the view that the market might be in for a sell-off as some families liquidate their investments to beat the increased taxation. The logic now becomes: If there is going to be added selling pressure coming in then we should take profits now, avoid the sell off and perhaps even buy back in at lower prices for a second bite of the cherry. A financial adviser now rings Family A and proposes that they trim their investments because a market pullback has increased as a risk.

The investors impacted by these proposed changes own the bulk of US financial assets

Substantially changing taxes for investors who own the vast bulk of financial assets in the US is absolutely a risk catalyst.

Combine in the fact that equity valuations have now lifted to reflect very low bond yields, so share prices no longer enjoy the same relative valuation appeal they enjoyed 5 months ago, and you have less of a case not to take profits. Finally bond yields are clearly under some pressure to increase as lenders are looking to be compensated for declines in their purchasing power as prices have been increasing.

In balance to these reasons to sell a very large amount of liquidity remains sloshing around in financial markets seeking a home and the opportunity cost of selling shares is reinvestment risk in bonds (yields may rise) or guaranteed negative real returns in cash.

Changed sentiment can result in contagion

With a substantial new risk catalyst dawning on the market, such as the doubling of capital gain tax, occurring when the relative attraction of shares to bonds has diminished due higher valuations, risk management red flags should be apparent.

This is especially the case for investors looking to ensure positive returns regardless of market conditions, which in turn means we need to be active calibrating the risks we are taking and the expected returns from those risks.

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