Is President Bush good for Wall Street? Until this spring, that was a hard case to make. During the first two years of the Bush Administration, Wall Street saw the S&P 500 sink by a cumulative 25 percent. A lingering recession sapped corporate earnings as job losses on Wall Street and Main Street, mounted. And, some would argue, the Administration's tentative response to the corporate accounting scandals of 2002 did little to restore investor confidence in the markets.
Now, all is forgiven — or at least forgotten. In May, President Bush, riding a wave of post-war popularity, wrestled a $350 billion tax cut out of a reluctant Congress. The bill's centerpiece is a huge cut to taxes on dividends and a lighter burden on capital gains.
The markets have responded with a gratifying leap (see cover story, page 28).
Suddenly, it seems, Wall Street loves the White House. “Bush recognizes the pressing need for an investment stimulus,” says Frank Fernandez, chief economist and director of research at the Securities Industry Association. “Investors are very disillusioned. This will help Wall Street.”
Bush's tax formula is simple: Lower taxes to stimulate spending, a la Ronald Reagan. In addition to cutting the dividend tax (a step toward its permanent elimination, according to GOP leaders), the measure accelerates the 2001 cut to the top income tax bracket from 38.6 percent to 35 percent, making it applicable for the 2003 tax year. The supply-side cuts, according to the Administration, will put more money into the hands of consumers and investors, creating new growth and jobs for the economy.
Back to Equities
Whether or not Wall Street believes that supply side economics work, the market has regarded them positively. Congress approved the cuts in early June, and, with some encouraging earnings reports from the first quarter, investors have been piling back into equities: On June 2, the S&P 500 was up by 18 percent from its March low (the Nasdaq had climbed by 25 percent from its March 11 lows).
In particular, the Street likes Bush's dividend cut, which advisors say might rekindle interest in equities. The most potent part of the measure for brokers and their clients is the dividend cut, which slices taxes to 15 percent for tax brackets over 25 percent (and to 5 percent for lower tax brackets). “No tax measure benefits the capital markets more than this,” says Fernandez. (But note: the taxes revert back to their pre-cut rates in 2009.)
Michael Esser, head of government relations at Edward Jones, thinks the dividend tax cut will put $20 billion a year back into investors' hands — mostly retired people. “It would provide a tax sheltered aspect to dividend paying stocks,” he says. He projects a higher stock market rise than many economists: 5 percent to 20 percent this year. Edwards Jones actively lobbied Congress for the dividend tax cut, directing 20,000 consumer calls to Congressmen. “With the projected rise of existing portfolios, brokers will have something positive to tell clients, leading to deeper relationships,” he says.
Chuck Gabriel, senior Washington analyst at Prudential Financial, figures the tax package will only “mildly stimulate” the economy near-term. But the fact that the Administration is doing something substantial is important in itself, Gabriel says. “It wasn't clear even last fall how sick this patient has been,” he says. “But Bush is like Popeye. He says what he means and means what he says. His team has a long-term focus on moving past a post-bubble world. He has won a set of friends on Wall Street.”
A side benefit of the dividend tax cut could be to restore confidence in corporate America, says Ian Davidson, chairman of Davidson Companies, a Great Falls, Mont.-based financial services firm. Davidson figures that by getting companies to focus on producing a dividend, the measure will force corporate executives to get back to fundamentals. “Corporations have forgotten who owns the company,” says Davidson. But, if companies have to produce actual profits and quarterly payouts to shareholders, rather than using every trick of aggressive accounting to keep the stock price (and their compensation) rising, the result could be better corporate governance. Between 1995 and 2000, nobody focused on the fundamentals, Davidson says: “That was the dumbest error in stock valuations in the history of the country.”
As the tax bill appeared increasingly likely to pass this spring, many brokers started preparing for the dividend tax cut. For example, Darius Sanandaji, a broker at Morgan Stanley's Oak Brook, Ill. office, began building a custom portfolio a few months ago. First, he screened the S&P 500, searching for companies with A or higher bond ratings. Then he screened the resulting 170 stocks according to company research on industry and weighting. The result: 38 stocks with current dividend yields that average 3.8 percent.
Sanandaji points out that dividend-paying stocks have outperformed non-dividend-paying shares during the slump anyway, because the dividend puts a floor under a stock. “They've done really well for clients,” he says. “And they've declined much less.” He has also suggested reallocating client portfolios from 40 percent stocks to 55 percent. The move to dividend-paying stocks “has helped my business a tremendous amount,” he says.
A study by T. Rowe Price supports Sanandaji's findings. Dividends represented 50.8 percent of the total return of the Standard & Poor's 500 index between 1980 and 2000. Yet U.S. tax systems have favored corporate retained earnings and using cash to buy back stock, says Davidson. In 2000, 129.3 million households filed federal tax returns; 26.2 percent of them received taxable dividend income.
Even economists who are skeptical about the effect of the cuts on the economy say that the Bush dividend tax plan should buoy the stock market. “Dividend tax cuts will have a good, strong effect on companies that are paying secure dividends,” says Dr. George von Furstenberg, a professor of economics at Indiana University. “Shares in those companies should appreciate significantly.”
How should advisors play the new dividend game? Tax issues might be a bit thorny at first. For example, clients could sell off non-dividend paying stocks, triggering capital gains. “Meet with clients and look at their 1040s,” says Hirshman, of JP Morgan Fleming. Talk with clients about how their tax liability and how current holdings are affected, she says. The clients who are most likely to move into dividend-paying stocks now (or add more) are retirees who have invested in tax-free bonds and investors in high-yield bonds.
Advisors should remember that clients moving from tax-free munis into dividend-paying equities are assuming a different set of risks, Hirshman cautions. “We don't want clients to fall into the trap of not understanding risk,” she says. “They shouldn't switch to dividend-paying stocks just because they feel the dividend will be higher.” Stock market risk is always a factor, she adds.
Many economists fear that the growing federal deficit, which will set new dollar records as the tax cuts are implemented, will put a drag on the recovery. A ballooning deficit is likely to push up interest rates, dampening the economy again. “We're giving revenue away as if there were no tomorrow,” says von Furstenberg. Meantime, the earnings news that helped the market this spring is the result of cutting expenses, like jobs, he says. Disturbingly, revenue growth is stuck in neutral, he says. “The economy is going to muddle through at crawl speed,” says von Furstenberg.
Even if the supply-side cuts prove to be stimulative, the budget problem could grow more acute. As baby boomers retire, they will be paying less in taxes and demanding more from entitlement programs. That trend will begin to kick in by the end of the decade, making a return to a balanced budget more difficult.
That looming liability is a huge concern, but one that can be used by advisors to generate more business from clients who need more than the hope of a solvent social security system to retire on. “Who's going to pick up the shortfall?” asks Steve Gresham, executive vice president of private client group at Phoenix Investment Partners. “Baby boomers haven't put nearly enough money into savings,” he says. “They've underestimated their future liability by a boatload. For the most part, people don't have much of a cushion.”
Gresham advises financial advisors to heed this call. “There's an enormous demographic of people awaiting their help,” he says. “The lack of government clarity makes the financial advisor more important.”
Another ticking time bomb is the savings rate. Including retirement plans, it currently sits at paltry 3.8 percent, according to the SIA (2 percent, if retirement plans are factored out.) Little in the current legislation is likely to have a direct impact on this situation. The original version of the tax-cut bill, introduced in January via President Bush's State of the Union address, featured savings and investment plans, including tax-free lifetime savings accounts. But those measures are now dead.
Nonetheless, for now, advisors will be happy to see anything that gives skittish investors a better feeling about the market. Fernandez, of the SIA, estimates that stock market activity is one-fourth of what it was just three years ago.
“Investors are very slow to come back to the market,” he says. “Our business is stunted. To avoid another downtown, we need the clearest stimulus we can find.”