The Buzz About Dividend Taxation

An article in Friday's "Wall Street Journal" bemoaned the fact that taxes on dividends could rise dramatically by the end of the year. Here is a quote from the article: "Last week the Senate Budget Committee passed a fiscal 2011 budget resolution that includes an increase in the top tax rate on dividends to 39.6% from the current 15%—a 164% increase. This blows past the 20% rate that President Obama proposed in his 2011 budget and which his economic advisers promised on these pages in 2008." A paragraph later the Journal heaps more pain onto their analysis of dividend taxation: "And that's only for starters. The recent health-care bill includes a 3.8% surcharge on all investment income, including dividends, beginning in 2013. This would nearly triple the top dividend rate to 43.4% in Mr. Obama's four years as President. We suppose the White House would call this another great victory for income equality." While these changes to dividend taxation are not yet the law of the land and the details may change by January 1, 2011, there is now ample evidence that the Bush dividend tax breaks enacted in 2003 will be allowed to die. That means that dividends in 2011 and beyond will be taxed at ordinary income rates. All of the talk about new taxes on dividends has prompted lots of questions about our dividend investment strategy after January 1. Here are a few important points to ponder: The first point is that dividends for most of my 35 years in the investment business have been taxed at ordinary income rates. So the the new taxes are not really new but merely a return to the old way dividends were taxed prior to 2003. The tax breaks of the past 7 years have been a blessing, but with the runaway government deficits this country is experiencing, it is too much to expect that President Obama would hold to his campaign promise of only hiking the tax on dividends to 20%. Because dividends have historically been taxed at ordinary income tax rates, many years ago we created two dividend investment styles. The first is called Cornerstone. Cornerstone currently consists of 30 stocks with an average dividend yield of just over 3% and 5-year average annual dividend growth of near 8.5%. The second is called Capital Builder. Capital Builder currently owns 31 stocks with an average current dividend yield of only 1.9% but the current portfolio has achieved a 5-year average annual dividend growth rate of over 12%. Capital Builder was created specifically for our clients in higher tax brackets. Its current dividend income is much lower than Cornerstone's but it makes up for it with higher dividend growth. Remarkably, however, the total annual rates of return for Cornerstone and Capital Builder have been within a quarter of one percent of each other over the last 15 years. Another important point to remember is that even though dividend taxes may rise, the 43.4% rate quoted in the "Wall Street Journal" only applies to families in the maximum tax bracket, which currently kicks in at about $374,000. There is talk that in the interest of squeezing more out of the "so-called" rich that the maximum tax bracket might be lowered to $250,000. Either way the new higher rates of taxation will only affect a small percentage of the population. Indeed, the current Federal Income Tax Guide shows that for families with taxable income up to about $68,000, the ordinary income tax rate is just under 15%. Taxable income between $68,000 and $137,000 is taxed at 25%. Thus, for many people the tax bite from higher dividend taxes will be very modest. To confuse matters more, the Bush income tax cuts of 2001 will also end on January 1, 2011. If Congress does not act, all income tax brackets will be rising by about 3%. Since President Obama ran on a pledge of no tax hikes for the middle class, we assume that Congress will pass legislation between now and year end that will freeze the Bush 2001 income tax brackets at their current levels, except for people making more than $250,000. Are you confused yet? Not any more than they are in Washington, and that is one of the reasons I have not ventured into the area of dividend taxation until now. It remains very much a moving target, and until the ink is dry I don't foresee that we will recommend many changes to our clients. There are many commentators saying that the reversion to the old form of taxation on dividends will cause American corporations to curtail dividend payments. I believe that line of thinking is completely false. Corporations know that the dividend is an important linchpin between themselves and their shareholders. In addition, dividends are cash money, and in a world of very low interest rates, there are millions of people who count on their dividend income to pay their bills. Corporations who cut dividends or try to sell the idea that they can do better with our money than we can won't get very far. The best examples of this are the major US banks. Almost all of them were forced to cut their dividends over the past 18 months. As their fortunes have improved, they are being besieged with questions about when they are going to reinstate their dividends. Keep an eye on interviews with bank CEOs. In almost every public conversation they are talking about their dividend policies. In summary taxes on dividends are probably going up, but we have been here before, and we have alternative investment styles that can minimize the effect of higher taxes. In addition as it relates to corporations' willingness to pay dividends, IBM just raised their dividend by 18%. IBM can read the headlines about dividend taxation just as well as we all can. If they were going to begin ratcheting down their dividend policy, why would they hike the dividend so sharply? They could have raised their dividend by a nominal amount and no one would have squawked. I believe they hiked the dividend by 18% because they are generating significant free cash flow and they wanted to reward their shareholders for sticking with them during the uncertain times of the last 18 months.

This Is a Classical Bull Market

For those of you who have hibernating in your bear caves, wake up, take a look at the chart at the right. This is no time for bears; this chart looks very much like a classical bull market -- higher highs, higher lows -- with significant tests along the way. The chart at the right is a 12-month chart of the Standard and Poors 500. It has climbed a proverbial wall of worry over the past 12 months and now sits at a new intermediate high. Yet as classical as is the bull market price chart, so too are the classical wailings of the bears who are left back at the abyss, staring into the dissipating darkness. The bull market in stocks is for real. It is not a reflex action, or an illusion. It has legs and it will continue to lay waste to any bears it encounters. The reason is simple: corporate earnings for the fourth quarter in a row are off the charts. These are not "less-bad" earnings, these are good earnings and good sales to boot, even dividends have started to tick higher. Indeed, it now appears that S&P 500 operating earnings for the first quarter will be up nearly 70% over the same quarter a year ago. Ah, but the bears cry out "Too far, too fast. The S&P 500 is up nearly 82% from its low of 670 on March 9, 2009. It cannot sustain this move; surely a correction of monumental proportions is near." (Please see comments section for a correction a loyal reader made) But I answer, "Too low, too fast." The market fell by nearly 50% from October 2008 to March 2009. It fell on fears that mankind was powerless to correct the calamity he had created in the subprime crisis. It fell on hope being tossed away as though it did not exist. It fell on every doom-filled tirade of the fear mongers. Finally it fell, well, because it fell yesterday." I have said many times that in understanding an upturn of the market, you must study the downturn. The chart at the right is a three-year chart of the S&P 500. It clearly shows how fast stocks fell from August and September of 2008 to the market bottom in March of 2009. Yes, indeed, stocks are moving higher, but they are moving higher in an orderly fashion with little signs, yet, that a capitulation by the bears has occured. And until the bears capitulate, the market's path of least resistance is up. Looking back at the first chart, it is clear that after the bottom was made in March of 2009, the S&P 500 has "saw toothed" it way higher, with buyers arriving every time the sellers started to take charge and sellers appearing each time the buyers appeared to be winning. This is what I mean by a classic bull market. It has been a tug of war trending higher. These kinds of classic "saw tooth" markets almost always occur after severe market corrections. Think of it this way: big sell offs in the market always come swiftly and sharply and are always accompanied by very bad news of some kind. Traders are slow to react to the encroaching bad news, but eventually capitulate by selling out, and excuse themselves for cutting bait at the bottom by saying that things can only get worse. They have no faith in history; they have no faith in the principles of economics. Evidence of this capitulation shows up in spikey price action such as that from November of 2008 through March of 2009. Here is a blog we wrote on March 20, 2009, just a little over a year ago. It is entitled "Is This the Bottom?" In it we briefly describe why we believed the market had collapsed and why we thought it was ready to turn higher. Here is a short quote from that blog: "Indeed, one could say that we are floating in a sea of value. All we need is for some sort of good news to propel stocks to much higher levels." In our judgment, we are still floating in a sea of value. Earnings are estimated to be up in 2010 by 25% and 20% in 2011. We are convinced the market has not priced in all the good news that is coming. Indeed, we will only start to worry about valuations when stock prices start getting spikey to the upside. That would mean that the bears have capitulated and become bulls. You know what comes after that!

Dividend Investing is Very Much Alive

We estimate that dividends for S&P 500 companies will rise by over 10% this year. If we are right, it will be the first year since 2007 that dividends for the S&P will have risen on a year over year basis. Indeed, dividends have taken a beating over the last two years, and there are those who say that dividend investing is dead. You won't be surprised if we don't see it that way. Our analysis of the dividend cuts for 2008 and 2009 reveals that the preponderance of the cuts were in the financial sector. Additionally, over the last three years, six of the nine major S&P industry sectors have raised their dividends (Consumer Cyclicals, Consumer Staples, Energy, Health-care,Tech, and Utilities), one sector kept dividends about the same (Industrials), and only two sectors cut dividends Financials and Materials). Here are five reasons that we believe dividends will rise in the coming year:

1. Corporate earnings are projected to grow by nearly 25%, with free cash flow growing even faster.
2. Loan loss reserves are peaking at many banks, and we are convinced that banks will begin hiking dividends as soon as the regulators allow it.
3. Corporations don't need to hoard cash since the capital markets have returned to near normal functioning.
4. Even among companies that don't want to commit to permanent dividend hikes, we believe many will choose to pay special one-time dividends as a reward to their shareholders.
5. In our judgment, corporate America is growing very weary of the run and gun stock trading crowd. Companies are becoming more and more anxious to attract shareholders who are interested in the long-term success of the company. The quarter-to-quarter trading crowd can never be successfully sold on the idea of investing in companies as opposed to stocks.

We'll report periodically in future blogs on how dividend growth is faring.