Financial advisers say clients are booking gains now at cheaper tax rate; 'better bang for the buck'
The highest-returning stocks of the bull market are trailing the Standard & Poor's 500 Index in September as investors book profits, anticipating that Congress will let tax cuts on capital gains expire at year-end.
About 250 of the largest American companies offer a dividend yield of at least 3 percent after rallying more than 50 percent since March 9, 2009, data compiled by Bloomberg show. Those stocks rose 6.8 percent on average in September, compared with the S&P 500's gain of 9.1 percent, Bloomberg data show.
The shares may face losses in October as investors dump stocks that might be subject to higher taxes, according to Leo Grohowski, chief investment officer at Bank of New York Mellon Corp.'s wealth management unit, and Brian Jacobsen of Wells Fargo Asset Management. Capital gains and dividend reductions enacted under President George W. Bush in 2003 will expire in three months unless Barack Obama and Congress extend them.
“We've seen an accelerated desire to harvest gains among investors who have large profits,” said Grohowski, who oversees $150 billion as chief investment officer at the Bank of New York division in Boston. “We see a number of clients who want to sell stocks where they have gains, not wanting to take a chance on the risk of much higher taxes.”
Heading Higher
Client selling has started and may accelerate in companies such as Downers Grove, Illinois-based Sara Lee Corp., which gained 111 percent including payouts since the end of the bear market on March 9, 2009, said Grohowski. Whitehouse Station, New Jersey-based Merck & Co., with its 4.1 percent dividend yield, is vulnerable, according to Jacobsen, chief portfolio strategist for the mutual fund division of Wells Fargo Asset Management, which oversees $467 billion in San Francisco.
Congress set a 15 percent tax rate in 2003 on capital gains for assets owned at least a year. Short-term profits are taxed at an individual's top ordinary rate, as high as 35 percent. Previously, the capital gains tax on assets held between one and five years was 20 percent and 18 percent when held five years or more. The 2003 law also reduced the tax on many dividends to 15 percent from ordinary income tax rates up to 35 percent.
Because Republicans are favored to control a majority of House seats after the Nov. 2 vote, the fate of the Bush tax cuts may depend on which party controls the Senate, where Democrats have a 59-41 majority. The Republicans stand to gain five seats while six elections are toss-ups, according to poll averages compiled by Real Clear Politics, a political website. The minority party needs to pick up 10 seats to gain control.
Capturing Gains
“Investors are capturing long-term capital gains now at the known rate of 15 percent instead of waiting to see what those rates will be like in 2011,” said Jacobsen. “It's sad that so many decisions are driven by tax considerations instead of being driven by what is most economically efficient.”
Alan Kufeld, a New York-based principal at accounting firm Rothstein Kass & Co., offered an example of an investor who has held 10,000 Sara Lee shares since March 9, 2009. Sold now, the capital gain tax would be $10,200. Sold next year after the cuts expire, the bill would be $13,600.
“We're telling clients to consider accelerating gains now, because rates are lower, and possibly deferring losses so when rates go up, which we do feel they will, at least they can get a better bang for the buck,” Kufeld said.
Among the 3,000 largest U.S. companies, about 250 are paying at least 3 percent annually and have climbed 50 percent or more since the S&P 500 began to rise from a 12-year low in March 2009. On average, they yield 5.3 percent and are up 129 percent, data compiled by Bloomberg show.
While Sara Lee, the maker of Ball Park hot dogs and Hillshire Farm meat products, has more than doubled over the past 18 months, it has dropped 5.6 percent in September. Merck, the second-largest U.S. drugmaker, has risen 5.6 percent this month, extending its gain since March 2009 to 75 percent. The S&P 500 is heading for the biggest September rally since 1939.
Stocks post below-average returns in years when capital- gains taxes are raised, according to Leuthold Group LLC, which has studied the market's performance since 1917. The Dow Jones Industrial Average rose 4.8 percent on average in the 11 years when the tax went up, trailing the 14.7 percent advance in the 10 years when the tax was lowered, Leuthold data showed.
“The difference in performance suggests that the stock market could face an uphill battle in 2011 when that cap gains tax increase goes into effect,” Doug Ramsey, Leuthold's director of research in Minneapolis, wrote in a note in July.
Tax Selling
Obama's administration will most likely allow tax cuts for the wealthiest Americans to expire after 2010, said Barry Knapp, chief U.S. equity strategist at Barclays Plc in New York. Should that happen, the S&P 500 may lose 100 points or more because the highest-paid individuals own three quarters of the market, Knapp estimated. The index closed yesterday at 1,144.73, compared with its record high of 1,565.15 in October 2007 and the low of 676.53 in March 2009.
At the end of the first quarter, about $10.4 trillion of stocks owned by American households and non-profit organizations, or 61 percent, were taxable, Barclays data show.
Tax concerns aren't enough to spur most investors to sell, said Todd M. Morgan, chairman of Bel Air Investment Advisors LLC in Los Angeles, which manages $5 billion. Morgan predicted any increase will be small and said the only people inclined to divest would be company insiders, he said.
“If you told me capital gains are going back to 30 percent, we'll have a different conversation,” he said. “But going to 15 to 20, it's not going to change people's investment soundness. It's more important for people that are founders and people that own huge blocks of stocks.”
The possibility of higher taxes has been enough to chase some managers away from the market, said Michael Yoshikami, who oversees about $1 billion at YCMNet Advisors in Walnut Creek, California.
“Institutional investors are strongly considering taking taxable capital gains this year rather than next year,” he said. “The likelihood of rising taxes does create a temptation for us to go ahead and take taxable gains this year.”
