The following message was emailed to all Edelman Financial clients on Friday, November 2nd.
Fiscal Cliff and Taxmageddon: A Primer
You’ve no doubt heard the terms Fiscal Cliff and Taxmageddon. They are frequently mentioned on talk radio shows, cable news networks and in newspaper columns.
But amidst all the bluster, we fear that there is great confusion about these terms, what they mean – or their implications for the economy and your investments. So, here’s a quick primer for you.
(And, allow me to say, in case this letter somehow winds up in the hands of a conspiracy theorist, it is a mere coincidence that we are sending this letter to you just days before the election. The content of this letter is intended to be strictly informational. We debated withholding it until after the election, but decided that we don’t want the election to interfere with our efforts to keep you informed about important financial matters.)
Both issues (yes, fiscal cliff and Taxmageddon are separate issues) are set to take effect on January 1, unless Congress acts. Obviously, there will be no action before next week’s election. The question is whether the lame duck Congress that returns to Washington after the election will act, or will it “punt” until after the new Congress takes office in January. If the new Congress acts, will it do so retroactively to January 1, or will new legislation take effect only as of the date the bill is signed into law by the (new?) president?
So, both of these issues might simply…go away. But on the assumption that they don’t – because Congress fails to act – here’s what will happen, and what it means for you.
First, taxes. For a variety of reasons, ranging from the expiration of the so-called “Bush Tax Cuts”, the payroll tax holiday (intended to help recover from the recession) and the new health care law commonly known as “Obamacare”, tax rates will rise for almost everyone on January 1 if Congress does not act. Here’s a rundown, according to the tax firm Ernst & Young:
- The federal capital gains tax rate will rise from 15% to a maximum of 24.7%.
- The federal tax rate on dividends will rise from 15% to a maximum of 44.7%.
- The federal tax rate on interest will rise from 15% to a maximum of 44.7%.
- The payroll tax will rise from 4.2% to a maximum of 6.2%.
- The estate tax, currently applicable to estates above $5 million, will be applied to estates worth just $1 million.
All this is referred to as “Taxmageddon.” Many economists fear that such a large, sudden increase in taxes will cause consumers to reduce spending – slowing the nation’s economic recovery or, worse, pushing us back into a recession.
The second issue, which pundits call the “fiscal cliff”, is formally known as sequestration. In August 2011, Congress and the White House avoided (at the last minute) a government shutdown by agreeing to impose a strict reduction in spending starting January 1, 2013. Left unchanged, $1.2 trillion must be removed from federal spending over nine years according to the law.
The reduction in spending is meant to prevent the federal debt from increasing – it’s $16 trillion and climbing. But instead of gradually reducing spending, the law (the Budget Control Act of 2011) imposes major, swift reductions in spending on January 1. So, instead of gradually reducing expenses over many years (imagine going down a gentle slope), federal spending will drop quickly (like falling off a ledge). In other words, a fiscal cliff.
Many economists say such a sudden, drastic reduction in federal spending will be a shock to the nation’s economy and will push us back into a recession. In fact, there isn’t much debate about that point. The debate’s focus is about what to do.
In our opinion, Congress will fix it – because the repercussions are both severe and obvious. As I’ve said for many years about the investment world, nobody ever gets hit by the bus they see coming – it’s too easy to step out of the way.
Thus, we believe common sense will prevail, with voters, lobbyists and special interest groups succeeding in efforts to convince Congress and the White House to address these issues.
But this notion raises a simple question: What if they don’t fix them? How should you handle your investments and the money in your retirement accounts at work?
Richard Bernstein, former chief investment strategist for Merrill Lynch, who was named ten times as the nation’s #1 investment strategist by Institutional Investor magazine, spoke at a conference of institutional money managers in Boston last week. According to Bloomberg, Bernstein said he believes the stock market is in the early stages of a bull market that could surpass that of 1982-1999.
Bernstein noted that the fears people mention today are the same as those expressed in the late ’70s and early ’80s: shrinking corporate profit margins, big entitlements and the federal deficit. All three were setting records at the time, just as they are now. We know how it turned out in the 1980s and 1990s, and Bernstein says he is highly optimistic for the next decade.
And here’s another interesting set of data, based on Contrarian Theory (the notion that you should do the opposite of whatever most people are saying, simply because most people are wrong!). According to Schaeffer's Investment Research’s latest survey of stock market analysts, the majority are bearish at present and thus encouraging investors to sell stocks. While it might seem scary to hear that the consensus of market analysts is negative, history shows that they are almost always wrong. The last time the consensus buy sentiment was this low was April 2010. Yet the stock market rose 15% that year.
Wall Street professionals aren’t the only ones who “buy high” and “sell low.” Ordinary investors do it, too. Since the stock market’s low in March 2009, investors have withdrawn $425 billion from stock mutual funds, according to Morningstar – even though prices have been steadily rising.
Likewise, look at the Yale School of Management’s Crash Confidence Index. This silly-sounding survey asks money managers if they believe the stock market will crash within the next six months. Right now, twice as many believe there will be a market crash as felt that way in October 2007, when the Dow was at its all-time high. Looks like they got it backwards!
All this supports that old adage that “Wall Street climbs a wall of worry.” People tend to be worried when they don’t need to be and excited when they should be worried.
Here’s the bottom line: There’s a huge difference between the economy and the stock market. Rising tax rates that reduce federal spending might damage the economy, but that does not necessarily mean that securities prices will fall.
If this seems surprising, consider the last four years. Since 2009, our nation has experienced the worst economy since the Great Depression – 43 months of unemployment rates above 8%, according to the Bureau of Labor Statistics, declines in housing prices in some areas of 50% or more, according to the National Association of Realtors, and more than 12 million mortgage foreclosures, according to Fannie Mae. And yet, during this period, the S&P 500 rose 14.8% per year. The Barclays Aggregate Bond Index rose 6.4%, and the EAFE foreign stock market index1 rose 8.9%, according to Bloomberg. How could investments do so well while the economy was struggling? It’s simple: The economy and the stock market are two different things.
The reason they are different is because the economy is “here and now” – do you have a job right now, what’s the value of your house right now, what’s the price of gasoline, food, health care and college right now?
Right now, we feel the impact of the current economy, and it’s dreadful. But the financial markets don’t care about that; they care about the future. You see, as leading economic indicators, securities prices – which tend to reflect what investors believe will happen six to nine months from now – usually rise or fall in anticipation of the future rather than due to events of the present. The past certainly doesn’t matter, which is ironic because many consumers focus only on the past.
To illustrate that last point, consider a recent survey by Franklin Templeton, a mutual fund company. Although the stock market gained 27% in 2009, 66% of respondents thought the market ended the year with a loss. Forty-eight percent of investors also thought the market fell in 2010, even though it rose 15%. And for 2011, 53% thought the market fell, when it actually rose 2%.
How could it be that so many people thought the stock market was doing poorly when, in fact, it has been doing great? The reason: People are focusing on the economy and they assume that since the economy is dreadful, the stock market must be dreadful, too.
But what if I’m wrong? What if the dreadful economy stays dreadful, and its dreadfulness spills over to the stock market?
In that case, here’s what we recommend: diversification.2
Yes, it’s as simple as that. We all know that there is much uncertainty at present – goodness, the election is on Tuesday! And with so many issues facing us domestically, politically, socially, economically, and globally, this is simply not the time for you to make a big bet.
And that’s really your choice, isn’t it? You’re either going to put all your money into one single type of investment, or you are going to buy many types of investments (called diversification).
Now, if you’re going to choose just one type of investment for all your money, you’re probably going to choose something safe. (I can’t imagine anyone placing his or her life’s savings into lottery tickets.) But if you choose safety, say by investing in bank certificates of deposit, the interest you earn – which is paltry these days, as you know – is subject to income taxes for many people. The buying power of your interest earnings is then further reduced by inflation.
You see the dilemma. Every investment has risks – even “safe” investments like bank CDs. We can’t avoid risks completely, but we can reduce them. And the best way we’ve found to do this is...diversification.
We can reduce investment risk by making many small investments in a wide array of investment categories. And that’s exactly what we do for you with the Edelman Managed Asset Program®. Your EMAP account has thousands of securities from dozens of countries, invested in more than a dozen asset classes and market sectors. While such broad diversification can’t protect against market losses, it can help reduce the risk of losses – or, at least, reduce the risk that your portfolio will be destroyed by a single event or loss of some kind.
Like you, we are frustrated with the situation we find our nation in. And that is why we will be at the polls on Tuesday, casting our votes. With the election so close, according to the pundits, every vote truly counts this election year. So we encourage you to vote on Tuesday and to make sure those around you vote, too.
Unless, of course, they plan to vote for the other guy!
Okay, that was a joke. But this isn’t: As we deal with the devastation left by Hurricane Sandy, I offer on behalf of all of us at Edelman Financial our thoughts and prayers to all those whose lives have been disrupted. If you have been financially impacted by the storm, please call your Edelman advisor. And if you know of someone who might need our help, invite them to contact us as well. May Sandy’s impact diminish as swiftly as she struck.
As for the election and the legislation that will follow, we’ll keep you posted as always.
Chairman and CEO
1An Index is a portfolio of specific securities (common examples are the S&P, DJIA, NASDAQ), the performance of which is often used as a benchmark in judging the relative performance of certain asset classes. Indexes are unmanaged portfolios and investors cannot invest directly in an index. Past performance does not guarantee future results.
2Diversification does not assure or guarantee better performance and cannot eliminate the risk of investment losses. There are no guarantees that a diversified portfolio will outperform a non-diversified portfolio.
Copyright © 2012 Edelman Financial Services. All rights reserved.
Ric Edelman is Chairman and CEO of Edelman Financial Services, a Registered Investment Adviser, and CEO, President and a Director of The Edelman Financial Group. He is an Investment Adviser Representative who offers advisory services through EFS and a Registered Principal of (and offers securities through) Sanders Morris Harris Inc., an affiliated broker/dealer, member FINRA/SIPC.