Investor Essentials Daily

Here’s what President Biden’s Tax plan means for your portfolio

April 5, 2021

Many people predicted a massive market correction if Biden won the 2020 election.

While our analysis said the same, the market has proved resilient, improving by 17% since election day. Nonetheless, our view of the market hasn’t changed.

Today, we discuss how Biden’s presidency might still impact the market, and what that means for your portfolio.

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If tax reform resembling Biden’s plan made it through the House and then the Senate, it could still have an effect on the market… and your portfolio.

Right now, the market’s price-to-earnings (P/E) ratio is supported by the low-tax and low-inflation environment. Low inflation is supporting high P/E ratios for the market. Low inflation means investors keep more money from their investments, and therefore are willing to pay higher prices for the same earnings.

Taxes have the same effect. With lower taxes, companies and investors can keep more of their investment after paying Uncle Sam, which allows the market to trade at higher P/E multiples. As you can see in the table below, a low-tax, low-inflation environment allows for a P/E ratio of around 20 times or greater.

However, a change in taxes would push down these multiples. Moderates like Manchin have expressed loose support for a corporate tax rate hike from 21% to 28%.

This tax hike could be a 9% headwind to the market. Real earnings would fall from higher taxes on pre-tax profits, forcing down the “E” (earnings) in the P/E ratio.

And if average capital gains taxes jumped to 39%, with dividend tax rates remaining the same, the aggregate tax rate will move closer to 30%. (Note that this 30% isn’t only for income or capital gains themselves, but an average tax based on the assets investors generate returns on, excluding tax-advantaged investment vehicles.)

This would mean the market P/E would drop to nearly 19 times. On a lower net income and a lower P/E ratio, the market could potentially fall 22%.

Of course, this would be a one-time drop before the market once again started moving higher. And as the rally since the election has shown, corporate earnings growth wins the day when it comes to longer-term stock market trends.

Furthermore, this is a worst-case scenario for valuations. It’s difficult to get elected officials to raise taxes, since they know a hike will hurt their election chances next time at the ballot box.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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