A new week brought new worries for the stock market. Moods were already downcast after the passing of Supreme Court icon Ruth Bader Ginsberg. Throughout her illustrious career Judge Ginsburg was a leader, a role model for working women and a staunch fighter for women’s rights. On Tuesday Prime Minister Boris Johnson told the British people to work from home if possible and ordered restaurants and bars to close early to counter a second wave of COVID-19. Johnson stopped short of imposing another full lockdown, as in March, but warned that more measures might be imposed if the virus were not contained. Newswire headlines announced US deaths from coronavirus surpassed 200,000 but failed to mention that the trend in new cases and deaths has decelerated dramatically. President Trump spoke (on video) to the 75th annual UN General Assembly and fueled fears of a geopolitical tiff by chiding China for unleashing COVID-19 on the world and stating that China needs to be held accountable for the destruction the plague has wrought by all members of the UN. The US Food and Drug Administration is expected to announce higher standards for an emergency authorization of any coronavirus vaccine, lowering the chances that a vaccine might be cleared before the November 3 election. And last but far from least, the first presidential debate scheduled for September 29th at 8:30 pm EST is merely one week away. This debate could become a pivotal factor for the stock market.
We believe last Friday’s Wall Street Journal’s article comparing Joe Biden’s and President Trump’s tax proposals may have been a contributing factor to the stock market’s recent decline. With Biden leading in the polls it is important for all investors to assess the impact a Democratic victory could have on the US economy. There are many factors to look at, but this week we will simplify it to tax policy.
President Donald J. Trump’s Tax Plan
President Trump’s tax policies are well known. He enacted tax breaks for individuals and corporations in 2017 and wants to extend these tax breaks past their current 2025 end date. Trump made it easier for corporations to bring home foreign profits and to deduct capital investment costs. Trump is currently proposing to cut the capital gain tax rate from the current 23.8% to 15% or 18.8%. And he wants to expand Opportunity Zones which offer capital gains tax breaks for investments in low income areas.
Vice President Joseph Biden’s Tax Plan
The Wall Street Journal article noted that Vice President Biden’s spending plans exceed his proposed tax revenue, but Biden explains this as stimulus for the economy. The Biden plan would raise taxes on individuals and entrepreneurs making more than $400,000 a year and would raise the corporate tax rate to 28%, impose a new minimum tax on companies and raise taxes on the foreign income of US based multinationals. His plan also includes reinstating the individual mandate to purchase health insurance, which is the proposal included in Obama care that the Supreme Court ruled was a tax on citizens. Mr. Biden proposes to raise the top individual tax rate of 37% to 39.6%, expand the 12.4% Social Security payroll tax which currently exempts wages above $137,700, but would restart the tax again on wages above $400,000. The plan also repeals a 20% deduction for income from pass-through businesses and impose new limits on itemized deductions. Most importantly, Biden would raise the capital gains tax rate from 23.8% to 39.6%, but reportedly only on households with income greater than $1 million. Nevertheless, this is likely to weaken the stock market prior to the election since many investors are apt to take profits on long-held stocks to avoid the possibility of this tax hike in 2021.
Millennials should take heed of structural changes to capital gains rules that Biden is proposing that could significantly impact their inheritances. At present, heirs only pay income taxes on gains in equity value that materializes after the original owner’s death and only when they sell the stock. Biden’s proposal would tax all unrealized gains as capital gains at the time of death. This is unsettling. Unless an heir has considerable liquidity at the time of inheritance this structural change would require an heir to sell much of the portfolio in order to pay taxes, incurring more capital gains taxes and potentially losing a significant amount of the inheritance. The very wealthy may have lawyers and accountants that can find a way around this tax, but Middle America will bear the brunt of this change.
All in all, we find the Biden proposals to be dicey for equities. Raising the capital gains tax rate has historically lowered stock prices in the short run as investors rush to avoid the tax hike and it lowers demand for equities over the longer-term since it raises the bar for speculators. All in all, a Republican sweep suggests more tax cuts while a Democratic sweep would bring increases.
Keep Some Powder Dry
Nonetheless, economic data has been strong. Housing data shows existing home sales rose to 6.0 million units in August, a 10.5% YOY increase. The median existing single-family home price rose 12% from a year earlier, while the average existing single-family home price gained 9% from a year ago. See page 3. August’s new home sales will be reported soon, but July’s data showed a 36.3% gain in units sold from a year earlier with median and average prices rising in the high single digits. See page 4. Homeownership also jumped from 65.3% in March to 67.9% in June, with the largest regional gain seen in the South where ownership rose from 67.6% to 71.1%. Black homeownership rose 3% to 47% and Hispanic ownership rose 2.5% to a record 51.4% in the second quarter of the year. See page 5. As a result, homebuilder confidence reached record heights in August. See page 6. In August, retail sales also reached a record level on a seasonally adjusted annualized basis and this tends to be a good forecaster of overall GDP. See page 7.
However, fundamental valuations remain stretched even as the Refinitiv/IBES consensus earnings estimate for the S&P 500 index continues to rise. This week’s estimate of $166.62 combined with a 20 PE multiple suggests a fair value level of SPX 3332, but as we show on pages 8-10 this still puts the equity market at the high end of fair value. It is possible that earnings estimates will continue to surprise on the upside, but the political climate is too uncertain to know. It is equally possible that higher corporate taxes would make current forecasts too high for 2021. In short, we remain cautious in the near term.
Technically, we see several important support levels that are worth monitoring. In the Dow Jones Industrial Average and in the Russell 2000 the 100-day and 200-day moving averages are converging. This makes the DJ 26,290 and the RUT 1457 levels crucial to the longer-term outlook. By holding at or near these levels the chart patterns improve. But breaks below these levels are highly likely to generate more selling. Breadth data is also showing some strain. The 10-day average of daily new lows fell to 76 this week and is below the 100 benchmark that characterizes a bull market cycle. The 25-day up/down volume oscillator is at minus 1.29 this week and at its lowest point since April 8, 2020. Corrections within a longer bull market cycle rarely reach a fully oversold reading on minus 3.0 or less; rather, corrections tend to reverse as this level nears. Overall, the risks in the market may only be political, but they are taking a toll on stock prices. We await the presidential debate next week.
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