“The word ‘politics’ is derived from the word ‘poly’, meaning ‘many’, and the word ‘ticks’, meaning ‘blood sucking parasites’.”
– Gore Vidal

Being a politician these days is akin to being a convicted felon. Unfortunately, most of the anger people have towards politicians is well deserved. If it were up to us, a prerequisite for any elected official would be an economics class that incorporates a history of both successful economic policies and, importantly, a thorough review of poor economic policies. The reason for this is very simple; those who cannot remember the past are condemned to repeat it. We currently see two tough lessons from the past that we believe are being repeated: raising taxes in a deep recession and artificially skewing equity returns by treating dividends as ordinary income.

Raising taxes during a recession.

Most politicians don’t understand what the economy is in its simplest form: a composite of all individual investment and spending decisions. For example, in 2009 consumers shut down spending and increased their savings. The savings rate went from being negative to solidly positive. Individuals made a decision to stop spending and start saving. With consumer spending representing about 2/3rds of our GDP, it is then not surprising that GDP turned negative the first quarter of 2009. It was only when individuals started feeling a little bit better about the economy that their spending increased and the economy started to grow again. Just as individuals made decisions to reduce spending last year, their financial decisions are now being influenced based on the potential for higher taxes in the future.

Individuals, especially small business owners, are making decisions today based on future tax rates. That is why so many people are converting their traditional IRAs to Roth IRA’s and selling appreciated stocks and recognizing income this year. In addition, most of our small business clients are not expanding (capital improvements and hiring) as they normally would because of the uncertainty regarding higher taxes and health care expenses. This is the exact same policy that occurred in the 1930’s and significantly prolonged the recession. If Congress decides to get rid of the “Bush tax cuts,” Congress will only make things worse. It is economics 101 – you don’t raise taxes in a recession. Nor do you create uncertainty for businesses. At this point, businesses do not know what to expect in the future. They need clarity and a clear set of rules. Currently, they are frozen and this is a drag on the overall economy.

Taxing of dividends as ordinary income

What is amazing about this change in policy is that it was only a few years ago (under Clinton) that we saw the capital gains rate fall while dividends remained taxed at the higher ordinary income tax rate. Next year, the capital gains rate will increase (for the highest income earners) from 15% to 20% while the tax on dividends will rise from 15% to 39.6%. This is a major increase in the cost of investing, particularly for those investing in high dividend paying stocks. Below is a chart showing the increase in taxes on $100 received in capital gains compared to $100 received in dividends:

In other words, those individuals that buy high dividend paying stocks will see those dividends taxed significantly higher than non-income producing stocks. This will have a major impact on style returns in the next few years.

After the capital gains tax rate was reduced in 1994, growth stocks significantly outperformed value stocks. Below is a chart comparing the current price/earnings ratio of large company growth stocks to large company value stocks. From 1994 through 2000, growth companies significantly outperformed value stocks. Today, growth stocks are at their lowest valuation compared to value stocks over the last 20 years.

Hence, we are expecting growth stocks to outperform over the next few years for several reasons? First, as just illustrated, they are at record low valuations compared to value stocks. Second, given the impending tax increases and investors’ propensity to pay less in taxes, they will prefer stocks that appreciate (lower capital gains rate) over those that generate income (high dividend paying stocks). Three, we believe corporations will change dividend policies going forward. They will pay out less in dividends then they otherwise would and instead use that money to buy back company shares. This will have the net affect of reducing the supply of shares available on the market. If supply shrinks and demand stays the same or rises, stocks will rise. By having a higher tax on dividend paying stocks, Congress will change the behavior of investing and cause growth stocks to outperform in the years ahead. We don’t believe that picking winners and losers in the stock market is an appropriate role for the Government.

Even though many of the current crop of politicians seem not to get it, the people do. Polls show that the number one issue on the voters’ minds is to stop the bloated spending. Stories showing up in USA Today such as the one about public sector employees making more than their private sector counterparts are changing public opinion. People are saying enough is enough. That is why New Jersey elected Chris Christie had more than 98% of his proposed budget approved by a Democrat-led legislature. This budget actually cut spending by more than 9%. Even Andrew Cuomo (the Democrat front runner for Governor of New York) is starting to espouse the same ideas as Chris Christie. There is a “wind of change” blowing throughout this country that is saying we have had enough of these “blood sucking parasites” wasting our hard earned money.