almost 3 years ago • 3 mins
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.
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.
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.
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.
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.
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.
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