Taxing Matter, Biden's Unsound Idea, Adapting to Change, Problems and Solutions

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New Math

The impact upon financial markets was as pronounced as it was immediate. Overdone? Perhaps. Any market where price discovery is controlled electronically by algorithms designed to overshoot based on micro-second reactions to keywords found on the Internet is going to experience exaggeration. Speed is how electronic traders force greater inefficiency into a marketplace where opportunity is created only through surprise; subsequently, surprise becomes the goal, not the process of finding the “right price.”

There may be a few human traders out there who still recall a time where finding the right price was the entire point of the whole discovery process. This is precisely why a handful of humans created a centralized point of sale under that buttonwood tree in the first place. If neither buyer nor seller were noticeably or immediately wrong (embarrassed), block traders were often congratulated for finding the right price. It was considered a skill.

The headlines broke first I believe at Bloomberg News, or at least that’s where I first saw the story. The algorithms that trade our markets saw it before any of us did; see if you can spot the time that this news story broke.

Hint: Equity markets had actually been fighting their way to a second straight “up” day ahead of the news. The headline news, of course, was that President Biden will speak next week with Congress in regard to his economic plans, or more specifically how to fund his economic plans as the nation emerges (or tries to emerge) from this awful pandemic.

The attention grabber on Thursday was the idea of increasing income taxes for the highest earners from the top tier of 37% to 39.6%, reducing the household income threshold for reaching that top tier from $500,000-plus to $400,000, and then for those elite-level earners ($1 million-plus taxing capital gains at the same rate as ordinary income. The 39.6% capital gains tax rate for these folks would be an increase from the current rate of 20%, so it would be quite significant if somehow passed, obviously slowing future investment, and if passed as a 2022 law forcing the words “long-term” out of any large investor’s trading strategy.

Markets

All 11 S&P sectors sold off on the news; defensive sectors, though still lower for the day, outperformed both growth and cyclical sectors. It does not take an economics degree to see how such a move, especially if coupled with other tax increases, such as corporate rates, estate taxes or lesser tax increases on non-elite earners, would relieve anyone at the central bank from worrying about overheating the economy or runaway inflation. Losers beat winners at both of New York’s primary exchanges as declining volume bested advancing volume. However, the margin of defeat for advancers was far less pronounced at the Nasdaq despite the last-place finish for the Nasdaq 100 among large-cap indices. Mid-Caps (S&P 400) and Small-Caps (Russell 2000, S&P 600) were hit less severely.

Aggregate trading volumes increased on Thursday from Wednesday’s “up” session after trading volumes decreased on Wednesday from both Monday and Tuesday’s “down” days. In short, professionals have started moving out of the equity space this week. There is no other way to interpret the trading volume. The silver lining would be that trading volumes have remained below their own 50-day simple moving averages (SMAs) all week, suggesting that enough portfolio managers have been indecisive up until now. That could be a positive, or it could mean that most of the pain is yet to come.

Overnight, equity index futures markets appear to be choosing to see this in a positive light, though I write this missive hours ahead of the earliest of North American traders even pulling those melons of theirs off of that greasy thing they call a pillow.

Uncertainty

The president had run for his current position basically pledging to increase both spending and taxation, so I guess none of this should be a surprise. The magnitude of this proposal is a bit shocking as once President Obama’s healthcare surtax on investment income (that still exists) for high-end investors is tacked on, the federal capital gains tax moves from 39.6% to 43.4%. For those living in high-tax states such as New York or California, once state and local taxes are included the capital gains tax bill rises above 52%. Clearly, the 43.4% would slow not just investment but also everything else that high earners do with their money, so slow labor markets, and broadly, slow the economy. Taxing 52% of capital gains for wealthier investors would likely put a complete end to investment from those states. There had already been an ongoing exodus. This would be the final nail.

The good news for wealthy folks, wealthy folks living in the wrong states, and anyone who works or would like to work for wealthy folks is that I believe that this is such a poor idea that it has to be the opening round of what is expected to be a lengthy process of negotiation. There is absolutely no way anyone on the president’s economics team OK’d this idea. It’s that unsound, fundamentally.

No doubt, the president is asking for a lot. Since taking office really just three months ago, the federal government has been able to enact a $1.9 trillion fiscal stimulus plan that included helicopter payouts, which was followed by the president’s proposed $2 trillion “infrastructure” bill. This, in turn, will be followed still by the “American Families Plan,” which will include another couple trillion dollars of spending more focused on social structure and education.

To counter (pay for) at least some of this planned and quite rapid increase in spending, there must a plan other than infinite borrowing and Modern Monetary Theory to pay for it. So, without an alternative — other than not spending on this scale — the president turns to taxation and hopes the recovering economy is not killed in the cradle. It’s already a safe bet that the corporate tax rate is going higher and that existing loopholes will be eliminated. It’s already a safe bet that taxes on foreign income earned by U.S. businesses are going higher.

Taxing wealthy individuals is different, though. This will meet problems in getting through both houses of the legislature, and not just as a partisan issue. You see, regardless of whatever rhetoric you subscribe to, most politicians on that level on both sides of the aisle are far wealthier than you or I could ever hope to be, and so are the donors they care most about. This will hurt many of those voting on passage, as well as many of those who pay in order to be heard.

Reaction

Should something pass that increased income taxes in general, and/or capital gains more specifically for higher-end investors, the timing of the law would matter. Should the law be backdated to January, this will slow both demand for equities as well as supply. Trading volumes would decline significantly as investors hope for a shift in power or a change in heart. Should the law be a 2022 story, there would be heavy supply, especially toward year’s end as these investors take profits in order to be taxed at Trump rates and not Biden rates. Those most “screwed” would be those with the most profits. Think growth stocks. Think bitcoin.

Oh, that reminds me. I told you I would be open with you about my Coinbase (COIN) long position. I have been day trading the issue, trying to keep the position at three-eighths of my original intention. That said, I did sell a tranche at a loss on Thursday immediately on seeing this news that I did not buy back, so I am down to one-quarter of a “full” position.

For markets more broadly, I think regardless of what finally passes there would be a good chance investors would move funds out of actively traded accounts and into tax-deferred or retirement accounts, slowing activity. Valuation will then normalize over some time. Other than that, all we can do as investors is understand our environment, identify both opportunities and challenges, and then adapt.

What Do We Know?

1) Overly expansive fiscal policy.

2) Overtly accommodative monetary policy.

3) Improving labor markets.

4) Rapidly growing economy.

5) Scarcity in critical areas.

What Remains Unknown?

1) Global path of viral spread.

2) Currency exchange rates.

3) Cross-border investment.

4) Foreign demand for the long end of the sovereign debt spectrum.

5) Domestic tax regime.

Sarge’s Problems & Solutions

In other words, what I am not selling because taxes may go higher but will add to on the dip if the rich folks do:

1) How to balance the pandemic economy with the economy of the re-opening.

Solution: The Walt Disney Company (DIS)

2) Global Vaccine Distribution.

Solution: Pfizer (PFE)

3) Defense against high-tech peer adversaries.

Solutions: Kratos Defense (KTOS) and Palantir (PLTR)

4) Semiconductor wafer fabrication.

Solution: KLA Corp. (KLAC)

5) Potential for consumer reaction to inflation (transitory or not).

Solutions: Dollar General (DG) and McDonald’s (MCD)

Economics (All Times Eastern)

09:45 – Markit Manufacturing PMI Flash (Apr): Expecting 60.2, Last 59.1.

09:45 – Markit Services PMI Flash (Apr): Expecting 61.3, Last 60.4.

10:00 – New Home Sales (Mar): Expecting 886K, Last 775K SAAR.

13:00 – Baker Hughes Oil Rig Count (Weekly): Last 344.

The Fed (All Times Eastern)

Fed Blackout period.

Today’s Earnings Highlights (Consensus EPS Expectations)

Before the Open: (AXP) (1.48), (HON) (1.79), (KMB) (1.94), (SLB) (.18)