Here's How a 'Blue Wave' Could Affect Your Portfolio

Joel Litman
         

When someone explains how big the universe is, numbers start to become meaningless…

It’s just too hard for us to wrap our minds around it. 

The Milky Way is 105,700 light-years wide. That’s 6.2137 x 10^17 miles (meaning, move the decimal place over 17 spots…).

If we had undertook the interstellar spacecraft mission Project Longshot when it was proposed in the late 1980s, it would have taken 100 years for Longshot to reach Alpha Centauri, our nearest neighboring star… And then another four years for the data to reach Earth upon arrival.

Even comprehending a 100-year mission is challenging for the human mind.

When you see a headline on U.S. GDP growth for the second quarter like we saw last Thursday, the cognitive dissonance of trying to comprehend this is similar…

What does a 32.9% shrink in second-quarter GDP even mean? It’s not as bad in Singapore – which saw a more than 40% drop – but it’s still mind-blowing.

And it’s important to realize that dip is inclusive of the U.S. government stepping in with stimulus and with unemployment benefits to help support consumption. 

The damage this pullback has had on the economy becomes more clear in this context, especially considering how bad this must mean the economic collapse was in April. 

These are also helpful data to qualify the type recovery we see – which we discussed last Monday.

With a drop that deep, it’s almost impossible to not have an initial rapid recovery.

Wall Street has many colorful sayings about cats… and one of traders’ favorite ones is about the “dead cat bounce” – a temporary recovery after a long decline. 

This is generally used when talking about chart patterns and quick drops in a stock or the market, but it’s just as true for the economy. We’re bound to see an initial sharp recovery after a steep drop, but we shouldn’t expect to extrapolate that linearly thereafter. 

With an economic drop this deep, and shorter-term series already showing that the recovery speed has slowed, it becomes more clear by the day we won’t be seeing a “V shaped” recovery. Instead we’ll be seeing a longer – and less easily described – road back to normalcy.

We received a lot of great reader questions about our recent article on inflation…

Last Monday, we talked about the shape of the economic recovery and the possibility of inflation. We also asked Altimetry Daily Authority readers where they thought the economy was heading.

We received several responses from readers like Stuart from New Jersey, who highlighted the signals they’re seeing that say that the initial snapback is slowing down. Others called into question the timing of when a vaccine will come into play, and if it will really have that much of a benefit.

But the most common refrain we saw – from Karen, Joe, Colin, and others – wasn’t about economics… it was about the election and what could happen to the market if Joe Biden wins the presidential election.

First, it’s important to understand that if Biden wins, it doesn’t necessarily mean taxes will skyrocket. We’ll get to the reason why in a bit.

That being said, it’s critical to understand the pressures to market valuations from high taxes before we can measure the effect of the November election.

In the October 21 Daily Authority, we talked about what taxes do to average market valuation. Now, let’s do a deep dive and explain three reasons why higher taxes will negatively affect your portfolio…

The first reason is the most obvious one. As corporate taxes rise, the earnings a company makes in relation to its revenue will fall. Assuming factors like inflation stay the same, as more of a firm’s pre-tax profit is paid to the government, stock prices fall – also assuming price-to-earnings (P/E) ratios stay the same. And yet, the real pressure to stock prices comes because P/E ratios change as well.

The second reason market valuations would fall is due to how taxes on dividends and capital gains affect P/E ratios. As investors are taxed a greater percentage of their capital gains and dividends, they need a higher pre-tax return to make the same amount of money. 

If an investor’s goal is to make a 10% gain in the market, in a market with a 0% capital gains tax rate, investors just need the market to rise 10%. However, if there’s a 20% capital gains tax, to reach that same 10% return, the pre-tax capital gains have to be 12.5%, since 20% of that gain (2.5%) will go to the government.

The pre-tax returns needed for investors to make their previous return will continue to rise as taxes climb. This means investors will pay a lower P/E ratio for any company they buy – driving down market valuations. This is because you need to start with a lower P/E ratio to justify higher stock appreciation, all else being equal.

The third reason is the effect of taxes on nominal gains, which doesn’t include inflation. This is why taxes and inflation together are key drivers of market valuations.

If an investor has a 10% pre-tax gain, but inflation is 10%… he didn’t actually make any money. If he now has to pay a 20% capital gains tax, the nominal (not inflation-adjusted) after-tax gain is 8%. Adjusted for the 10% inflation rate, this investor lost around 2% on a real basis. 

This is why understanding taxes and inflation is so important to understanding market valuations. In total, these three interacting consequences of taxation directly affect P/E ratios of the stock market, all other factors being equal. 

As you can see below, if inflation remained constant between 0% and 4%, the U.S. moving from a low-tax environment to a high-tax one would lower average P/E ratios from 20.1 to 16.3…

However, if Biden wins the election, this doesn’t guarantee taxes will be higher. Even more important for investors, it doesn’t mean the market will immediately plummet.

The market won’t instantly drop after a theoretical Biden win partly due to how wealth advisors think about changing an investor’s entire portfolio strategy on the potential for a future tax hike.

If a wealth manager sold an entire portfolio’s worth of capital gains at the risk of higher taxes, and the bill never comes to fruition, clients will be unhappy they paid so much capital gains tax for nothing!

This means fund managers, advisors, and traders will wait until after a law is passed and when they’re able to read the fine print of the tax change before making any conclusions on changing their strategy. Even if it is clear taxes are rising, the “how” is important before the markets react.

The other reason a Biden victory doesn’t spell doom for the market is a question of the strength of the “blue wave,” should it come. The president doesn’t govern on his own – this requires working with the Senate and House of Representatives.

If the Senate doesn’t win a filibuster-proof majority (which currently isn’t a certainty), or the Democrats miss the mark in the House (which admittedly is more of a longshot), the government will be split.

Historically, if government control is split, that means gridlock in Washington. And gridlock is good for the markets because it means things don’t change, which reduces uncertainty for the market. In this case, it mostly reduces negative potential outcomes related to taxes.

And even if Biden does get a strong “blue wave,” some of those new Senators will be coming from regions where they will need to walk a moderate political line. For example, recall how Sen. Joe Manchin of West Virginia has voted since he got elected in a “purple” West Virginia – while it votes democratically, the region is more conservative.

This is why the idea of wholesale changes to the tax code undoing 40 years of lowering taxes is unlikely, even if there could be some cosmetic changes. And investor panic about the negative of a positive electoral cycle for the Democratic Party is likely overblown. 

As a reminder, we wouldn’t be the first to point out that the stock market has often performed well during Democratic administrations as well as Republican ones. If there’s a gridlocked D.C., that’s generally great for the stock market… no matter who’s living at 1600 Pennsylvania Ave.

Regards,

Joel Litman
August 3, 2020