Why A Mooted Tax Hike On The 1% Could Damage One Of Your Favorite Strategies

Why A Mooted Tax Hike On The 1% Could Damage One Of Your Favorite Strategies
Andrew Rummer

almost 3 years ago3 mins

Mentioned in story

What’s going on here?

A proposed increase in US taxes on capital gains – a.k.a. personal investment profit – spooked markets last week. And while the long-term impact on stocks is likely to be muted, small investors’ fondness for momentum-based strategies could see you and I taking a bigger hit.   

What does this mean?

The US president reportedly wants to hike the top rate of long-term capital gains tax for those with a total income of more than $1 million a year: from 23.8%, where it’s sat since January 2013, to 43.4%. While that’s only going to affect the richest 0.3% of Americans, this ultra-wealthy cohort owns a massive chunk of the stock market – and therefore has outsize clout should they decide to sell some of their shares and take out profits before the higher rate comes into force. 

The richest 1% hold 53% of all US household stock investment, according to bank Goldman Sachs. And with households between them the largest owners of US stocks – controlling 35% of the market – that means almost a fifth of the American stock market is owned by these one-percenters. 

Of course, there’s no guarantee the capital gains tax proposals will make it through Congress and into law. Even if they do pass, it’s unclear when exactly any increase would come into force. But the issue is rattling investors’ radar nevertheless, and particularly for those backing the market’s best-performing stocks.

The last three times the US increased capital gains tax, stocks fell in anticipation of the change. The benchmark S&P 500 index dropped by an average of about 3% in the six months preceding the hike – but rebounded strongly afterwards. 

Market reaction to previous tax increases
Source: Goldman Sachs, FactSet, Federal Reserve

The impact on the overall stock market has, historically, been marginal. Yet because more investors will be sitting on gains in those investments that have delivered the biggest returns recently, the stock market’s recent winners may be subject to more selling than others. The table below shows the shares that would potentially be hardest hit – from automaker Tesla to casino operator Caesars Entertainment.

Table of stocks with biggest recent gains
Source: Goldman Sachs, FactSet

And don’t forget that capital gains tax is payable on all investment returns, not just those from stocks. That might also mean downward pressure to come for the price of bitcoin and other cryptocurrencies that have experienced meteoric booms in recent years. 

Why should I care?

By hitting winning investments hardest, the planned capital gains tax hike has the potential to dent one of the most successful investing strategies of recent years: momentum

Investors adopting a momentum strategy essentially bet that those stocks – or other assets like crypto – that have climbed most recently will go on rising. It’s provided market-beating returns over the past five years, as this chart of the iShares MSCI USA Momentum Factor exchange-traded fund (ETF) compared to the SPDR S&P 500 ETF demonstrates. 

Performance of momentum strategy
Source: Bloomberg

So while any hit to the overall stock market from this capital gains tax increase would likely be minimal, any hike could well prove a short-term setback at least for those who like to buy stocks that have been rising recently – a category which may well include you.

Key takeaways

  • History suggests that the impact on the overall stock market from any increase in US capital gains tax would be small.
  • There might nevertheless be outsize selling of the best-performing investments as the wealthy lock in gains before the higher rate came into force.
  • This would hit recent high-flyers like Tesla shares and bitcoin, and could dent the returns of popular momentum trading strategies.
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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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