An important development during the first quarter was the passage of Health Care Reform. At over 1,900 pages, this bill will have sweeping changes on our health care system. While there are strong opinions on many sides, what does this mean for investors?
A significant result of the bill is an increase in taxes for upper income Americans. Starting in 2013, the Medicare tax rate on households with income over $250,000 will be increased from 1.45% to 2.35%. In addition, a new 3.8% Medicare tax will be introduced for the same group on investment income. Currently, the tax rate on dividends and long term capital gains is 15%. In 2011 tax rates are expected to rise to 20% for households earning over $250,000, and with the new Medicare tax, these rates will rise to 23.8% for the same group. Under current tax law, investors get to keep 85% of the income stream from taxable stock market investments. Under the new law, this will be cut by 8.8% to 76.2%, reducing the value of the income stream by 10.4% (e.g., 8.8% of 85%). While this is a significant number, we need to consider that roughly half of US stocks are owned by households with income under $250,000 and about half are held in non-taxable accounts. So, the value of the average stock should be reduced but not to the extent that some may believe. In addition, stocks should still be attractive relative to bonds: the maximum tax rate on bond and cash income is currently 35% which will rise to 43.4% for incomes over $250,000 in 2011. Finally, these rates are not unprecedented: on average over the last 40 years, the maximum federal tax on capital gains has been 24.7% and the maximum tax rate on dividends has been 44.6%.
There are certainly many other impacts of this bill—such as the implications for the medical care industry and federal deficit. However, despite some dire predictions, many of the economic negatives of this bill will not begin for several years. By then it is likely that the current recovery may be in full swing, which has the potential to somewhat dampen the negative effects of the bill. Given the complexity of the bill and its multi-year implementation, it may be a long time before its true costs and benefits are accurately determined.
Speaking of the economy, we were blessed with yet another unexpectedly strong quarter of performance for the US stock market. As we have been saying for over a year, we have a strong conviction in the resiliency of the US economy and its businesses. Although the financial system came perilously close to a complete meltdown in late 2008 and there still are many problems to be addressed, we believe the economy and consumer sentiment has rebounded more quickly than many were anticipating. This is important because consumers comprise more than two-thirds of the economy. As such, they are critical to an economic recovery. While unemployment remains high, other leading indicators imply that the recovery is well underway.
Outlook
You may recall that I wrote a paragraph last quarter titled “Blinded by the Pessimists”. Interestingly, on April 12th panelists on the CNBC Squawk Box were discussing this very subject—the fact that investors have a tendency to continue to overemphasize the negative during a downturn and to continue to overemphasize the positive during an economic expansion. Both can be troubling because one can get “stuck” for too long in one of these camps. Meanwhile the economy and the markets can be changing. We believe that an economic recovery is underway and that holding too much cash or bonds right now has the potential of causing investors to miss a strong period. (Historically stock markets have moved the most at the beginning of an economic recovery.) In the context of an appropriate asset allocation plan, we are emphasizing medium and small companies, and international and emerging markets stocks and bonds. To further diversify, we are including selected areas such as real estate, health care and alternative investments for their long term potential. Inflation, while tame currently, remains a long term concern for bond investors. As such, we are emphasizing bonds that we believe will be affected to a lesser extent when inflation and interest rates rise.
Lyman H. Jackson, CFP®, MBA
Total Returns – December 31, 2009 (%)
Quarter 12 Months Trailing 5 Years Annualized
S&P 500 5.4 49.8 1.9
Large company stocks 5.2 44.0 2.8
Medium-sized company stocks 8.4 57.1 4.8
Small company stocks 9.4 52.2 4.2
Foreign stocks 0.2 50.0 1.0
Taxable bonds 1.8 7.7 5.4
Past performance is not a guarantee of future results. Indices are unmanaged and investors are not able to invest directly in any index. Foreign investments involve special risks including greater economic, political and currency fluctuation risks, which may be even greater in emerging markets. Smaller-company stocks have experienced a greater degree of market volatility than large-cap stocks. Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation, market valuations, prepayments, corporate events, tax ramifications and other factors. Unlike stocks, bonds offer a fixed interest rate and return of principal if held until maturity. The price of commodities is subject to substantial price fluctuations during short periods and may be affected by unpredictable international monetary and political polices. The market for commodities is widely unregulated. Concentrated investing may lead to higher price volatility. Alternative investments involve specific risks that may be greater than those associated with traditional investments. See index definitions below.
Investing involves risk including the potential loss of principal. No strategy can assure a profit nor protect against loss. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. The views expressed are not necessarily the opinion of Royal Alliance Associates, and should not be construed directly or indirectly, as an offer to buy or sell any securities mentioned herein.
Standard and Poor’s 500 Index (S&P 500®) is an unmanaged, capitalization-weighted index of 500 stocks. This index includes 500 blue chip, large cap stocks which together represent about 75% of the total US equities market. Companies eligible for addition to the S&P 500 have market capitalization of at least $4 billion.
Large companies are represented by the Russell 1000® Index. This index measures the performance of the large-cap segment of the U.S. equity universe. It is a subset of the Russell 3000® Index and includes approximately 1,000 of the largest securities based on a combination of their market cap and current index membership. The Russell 1000 represents approximately 90% of the U.S. market.
Medium-sized companies are represented by the Russell Midcap® Index. This index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap Index is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap Index represents approximately 27% of the total market capitalization of the Russell 1000 companies.
Small companies are represented by the Russell 2000® Index. This index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 8% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
Foreign stocks are represented by the MSCI EAFE Index® denominated in US dollars, dividends reinvested net of taxes. The index is comprised of 21 MSCI country indices, representing the developed markets outside of North America: Europe, Australasia and the Far East. MSCI aims to include in its international indices 85% of the free float-adjusted market capitalization in each industry group, within each country.
Taxable bonds are represented by the Barclays Aggregate Bond Total Return Index, a market value-weighted index that tracks the daily price, coupon, pay-downs, and total return performance of fixed-rate, publicly placed, dollar-denominated, and non-convertible investment grade debt issues with at least $100 million par amount outstanding and with at least one year to final maturity. Total return includes dividends reinvested into the index.
Advisory services offered by Jackson Financial Advisors, Inc., a Registered Investment Advisor. Securities offered by Royal Alliance Associates, Inc., Member FINRA, SIPC. Jackson Financial Advisors is not affiliated with Royal Alliance.
