How a Democratic victory tomorrow could affect your portfolio
Tomorrow’s election has the ability to alter the stock market and the economy for at least the next four years. The two presidential candidates have different corporate and personal tax plans, which may cause the market to swing in either direction.
Today, we look at what a Biden win could mean for your portfolio over the next several years.
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Biden’s lead in the presidential race has widened over the past few months. According to the statistics website FiveThirtyEight, he has an 89% chance to win the electoral college. That’s a big change from a 67% chance two months ago.
Similarly, FiveThirtyEight’s senate forecasts have also shifted. Democrats now have a 76% chance to win a majority in the upper chamber. This is up from a 57% chance two months ago.
As 2016 showed, the polls are not always correct, so anything can still happen tomorrow. However, most of the data point to a “blue wave.”
This means there could be a shift in tax policy. The possible changes will be on the top of investors’ minds between tomorrow and inauguration if the Democrats gain power.
Biden is planning to increase the corporate tax rate and the marginal tax rate on high earners. Additionally, he has floated the idea of taxing long-term capital gains and dividends at the same rate as ordinary income for those with an annual income above $1 million.
The current long-term capital gains and dividend tax rate for the highest bracket is 20%. Under Biden, the benefits of stocks could change for the ultra-rich.
This could have large implications on the market.
Biden’s proposed 40% capital gains & dividend tax for high earners sounds terrifying on paper. Some people think it means the market will crater if Biden wins.
It’s important to note that short-term capital gains are already treated as income. In other words, gains on investments held for less than a year don’t enjoy any tax breaks. Additionally, less than 0.5% of Americans make $1 million annually, meaning the proposed change leaves most investors unscathed.
Biden has also resisted pressure from more progressive party members. He has dismissed calls to tax unrealized capital gains.
Overall, Biden’s proposal is not as dire as it looks.
Furthermore, we have a framework here at Valens to understand the implications of tax changes.
As we’ve previously discussed, our framework looks at the inflation rate and the capital gains tax rate to see what the expected P/E ratio for the market should be.
Right now, inflation expectations are low. We predict rates to stay between 1% and 2%. Additionally, the aggregate tax rate across short-term investments, long-term investments, and dividends is 20%, which is low compared to historical averages.
This translates to an implied P/E ratio of roughly 22x. Unsurprisingly, this is near where the market’s average Uniform P/E has been over the past handful of years.
Now, to model the potential market impact, we need to adjust the tax rate. The proposed 40% tax is not for all investors, but it will impact a large part of the market. If we model the average tax rate to rise to 35%, market multiples would drop to 17.6x.
That’s a significant dip in valuations. It implies a 21% drop in the stock market from current levels.
For context, an average tax rate of 30% would imply a 15% drop in the market. The above examples imply Biden is able to fully implement his plan. In a more likely scenario, where Biden’s proposals are moderated, a realistic 25% tax rate would only mean an 8% drop in the market.
Personal tax rates are not the only factor. Another piece of the puzzle is corporate tax rates. Biden also wants to increase corporate tax rates from 21% to 28%. This could hurt corporate earnings.
If you apply the same change in market multiples to this reduced earnings number, the potential drop in the market ends up between 8% and 32%.
A 32% drop seems catastrophic, but there are three important reasons why this is not likely to happen.
First, a blue wave would be driven by converting moderate senators. The Democrats who can give their party a majority in the senate are from more moderate or conservative states. If Steve Bullock from Montana or Theresa Greenfield from Iowa join the Democratic caucus, they may not be on board with raising the corporate tax rate. At least not if they want to eventually win re-election.
Second, it would only be a one-time drop. A 28% corporate tax rate would still be lower than it has been historically.
Earnings growth analysis from before and after the Trump corporate tax cut does not show any meaningful sustained boost in earnings growth. So, a raise would similarly be unlikely to impact longer-term earnings growth. Organic corporate earnings growth could make up this type of drop in the market in short-order.
Third, and most critically, these changes will not all happen at once. Bills take a long time to become laws in Washington D.C. Therefore, wealth managers and intelligent investors usually do not react to changing tax policies until they become law.
All of this is to say that there’s no need to liquidate your investments if Biden is elected tomorrow.
There is a lot of nuance in tax laws, so it’s best to avoid acting prematurely.
It’s still important to watch the election results with your portfolio in mind; just know the worst-case scenario is minimal in the long-term.
If the worst scenario struck, a 32% drop would feel terrible in the short-term, but it is low probability. Importantly, if your money is in the stock market because of its long-term potential, trying to time the drop and reinvest at the bottom is a fool’s errand. Just wait and the market will rise again.
Continue to be smart and calculating, and remember that emotions and your money should not mix.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research