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Partners in Building Wealth

The Fiscal Cliff – Strategies to Consider

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The press is focused on the pending “fiscal cliff” – the January 1st expiration of the Bush era tax cuts, the need to reduce Social Security, Medicare and Medicaid benefits and the pending automatic cuts in defense and healthcare spending. We are at a critical point where we need to balance reducing the country’s debt level against support of an economic growth rate that is modest and slower than normal. Higher taxes would reduce funds available for spending which is critical in our consumer- driven economy. The end result if nothing is done by year-end is a financial superstorm, which all agree should be avoided if at all possible.

We need tax reform, higher revenues and reduced government spending. We need long term entitlement reform and a significant increase in government revenues. Unfortunately, what we are likely to see is a postponement again while our politicians respond to this wakeup call and hopefully find common ground.

Going over the cliff is implausible and avoidable. Politicians and investors are in agreement that to do nothing is economic suicide. Most everyone feels there will be a compromise – perhaps a six to nine month extension to allow Congress and the President to agree on a plan. Hopefully solutions to the growing problem will be reached and we can move forward toward a balanced budget.

In the meantime, this uncertainty is causing economic and capital market headwinds around the world. Corporations are not hiring or building plants, individuals are worried and holding cash and pundits’ predictions for a resolution are all over the map. How do you invest in this environment?

It is impossible to know with certainty what the resolution will be.  What we do know is this is not a black swan – a surprise event that will cause a dramatic decline in the stock market. This feels more like Y2K – when we all expected the cyber world to cease at the turn of the century. It passed without fanfare. The “fiscal cliff” is a very real problem, but it is likely that the resolution will be a relief, regardless of how significant the measures are. Our economy is on the mend. Housing is recovering and corporate balance sheets are strong.

It is difficult to know what will happen in the short run or what the long term stock market implications will be. However, it is likely the growing concerns as we approach year-end will provide buying opportunities for patient, long term investors. In the meantime, what are some things we should consider if we are individual investors in an uncertain tax and investment world?

There are many plans or suggestions floating around to address our deficit. Here are some of the possible changes being discussed and comments as they relate to investing. Taxes or other considerations should not drive investment decisions but there are several things that can be considered as we approach the end of the year:

Capital Gains Taxes

It appears likely capital gains tax rate will increase at the Federal level after January 1st. The rate of tax based on the Bush era tax cuts is presently 15%. This is scheduled to rise to 20%. The current plan also calls for a 3.8% surcharge on income over a certain amount as part of the Affordable Care Act and capital gains are included in the calculation.  The base gains tax rate could actually be higher than 20%. There are suggestions that capital gains be taxed at the ordinary income tax rate for investors with higher incomes. If you have very low cost basis holdings and plan to trim them over time you might consider realizing more gains in 2012. This has to be considered in the context of your overall tax situation and the attractiveness of the investment. Consulting your tax advisor is recommended well before the end of the year.

Dividend Income

Dividends are also taxed today at 15% and the rate is expected to increase to 39.6% with the same 3.8% surcharge for higher tax bracket investors if no compromise is reached. This would reduce the after-tax return from stocks, especially those companies that pay out a high percentage of their earnings in dividends. It would reduce the net income for many investors who are living on their investments. It may also change the behavior of corporations; they are likely to buy back stock or reinvest earnings rather than increase their dividends. Keep in mind that pension funds, retirement accounts and other non-taxable accounts do not pay taxes and this added tax does not directly impact them. The best strategy is to buy companies that pay out less than 50% of their earnings in dividends and have strong fundamentals.  This higher tax may impact the performance of very high yielding companies that have little to offer but dividends. It is doubtful companies will cut their dividends and it is difficult to strategize this change. Quality companies with strong earnings should continue to do well.

Estate Taxes

The most significant change if a compromise is not reached by year end is the tax on estates. Today investors can leave $5 million to their heirs without tax.  Estates over $5 million are taxed at a rate of up to 35%. After January 1st (if a change is this area is not negotiated) the amount of exemption drops to $1 million and the rate goes as high as 55%. This tax applies to a relatively small number of families but has tremendous impact on those affected. An increase in this tax is expected given that this involves the “wealthy”, it raises revenue and does not involve the middle class. If your estate is sizeable you might want to talk with your attorney about increased gifts to family members or charities or other strategies this year to take advantage of today’s higher exemption.

Income Tax Deductions

Both political parties have made mention of eliminating income tax deductions for the wealthy with the most common definition of wealthy defined as income of $200,000 per year for single tax payers  and $250,000 per year for married couples. Very small changes in allowed deductions could have significant implications. For example, if mortgage interest deduction amounts are reduced or capped for taxpayers at a lower income amount it would hurt an already fragile housing market. If charitable deductions are reduced many non-profits will suffer. It is not clear where these discussions are headed and impossible to plan beyond this year. The elimination or reduction of the tax exemption on tax free bond interest would hurt the states and municipalities. The tax free bond market has not reacted to this discussion. The common view seems to be that it is unlikely that an elimination of the interest deductions would make it through these negotiations. Sale of quality municipal bonds in anticipation of such a possibility could be a mistake.

Investment Strategies

The free world is watching what we do and the credit agencies have warned that they will not hesitate to further downgrade our credit rating if we do not reduce our debt. This might cause our interest rates to rise as our bonds become lower quality and foreigners no longer see us as the go to country to safely invest reserves. This, together with low historic interest rates, means that bonds, and especially U.S. government bonds, may not be attractive. The 10 year US Treasury bond is yielding 1.6% while stocks are yielding 2.3% (as measured by the S&P 500). Long term bonds will not be an attractive investment if we do not reach some compromise and find a promising solution to reduce our deficit.  Intermediate and shorter term bonds are the most conservative during this period of uncertainty.

The stock market focus immediately shifted to the fiscal cliff the day after the election. There is more of the same in Washington – political gridlock and two parties at odds. It is hard to see how a compromise of any significance can happen unless both move toward the middle. The Republicans refuse to raise taxes while President Obama and the Democrats stand firm on their refusal to reduce entitlement benefits. As the rhetoric rises investors will worry and stocks could continue to decline. This may be a good opportunity to add to quality companies.

The stock market reacts more today to economic headlines than company fundamentals making this an ideal time to invest in stocks if you are a long term investor. There is a disconnect between the concerns for the economy and the strength of US Companies that are flush with cash. Balance sheets are very strong and earnings, while slowing, are still strong. The old adage, buy on fear and sell on greed, may prove very true here as investors hoard cash waiting for a resolution. A recession generated by inaction in Washington would be difficult. However, stock prices are close to discounting no action and another recession.  If this doesn’t happen and a compromise is reached it will be positive for stocks. If a postponement is not announced or an agreement is not reached before year-end, the stock market may react and decline on the news but a massive decline like we saw in 2008 is unlikely. We are not at bubble levels and valuations are low relative to history.

It would be a mistake to sell stocks and raise cash. We have no idea where the negotiations are headed but it is safe to assume all agree that to do nothing is not an attractive alternative.  It would not solve the problem while possibly sending us over the cliff into recession. Selling quality stocks that may already discount the problem to hold cash yielding almost nothing is a low return strategy.

As fear grows so does the buying opportunity. Think long term and take advantage of these short term concerns. We have to solve our serious deficit problem in years to come but any start at this point will most likely be perceived positively by a stock market that hasn’t ignored the possible plunge over the fiscal cliff.

Mary M. Bersot CFA