The Fiscal Cliff: How Far Could Stocks Fall?

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 |  Includes: SPY
by: Stephen Barnes

Many folks believe that Congress and the President will reach a compromise in time to avert the dreaded "fiscal cliff." But what if we don't get a compromise? What are the implications for stocks then? How far could stocks fall? It's very difficult to say. Nevertheless, in this article, I attempt to give you an answer.

Background

"Fiscal cliff" is a term coined by the media to describe the point in time - midnight on December 31, 2012 - when provisions of the Budget Control Act of 2011 will go into effect absent further action by Congress and the President. Left unchanged, these provisions will require the federal government to cut spending and increase federal tax rates, all in an effort to reduce the budget deficit. The two tax rates of particular concern to investors are the dividend tax rate and the capital gains tax rate.

Back in 2003, the tax rate on dividend income was decreased to 15% as part of the Jobs and Growth Tax Relief Reconciliation Act of 2003. After December 31, 2012, dividend income will be taxed at the ordinary income tax rates in effect in 2000. This means, unless the "fiscal cliff" is averted, those in the highest income tax bracket will be required to hand over 39.6% of their dividend income to the federal government. The capital gains tax rate will also increase to 20%. It doesn't take a rocket scientist to see that an increase in these tax rates will cause stocks to become less attractive to investors, leading to a decline in stock prices. So, how far could stock prices fall if the country goes off the "fiscal cliff" at the end of the year?

Estimating the Impact

Analysis from NYU's Aswath Damodaran

Although it is difficult to quantify the impact the dividend and capital gains portions of the "fiscal cliff" will have on stocks, valuation guru and NYU Finance Professor Aswath Damodaran recently gave it a shot. In a blog post dated September 27, 2012, Damodaran provides detailed estimates regarding the extent to which stock prices could fall if the tax rates on dividend income and capital gains increase come 2013. Damodaran's post even contains a link to download the spreadsheet he used to compute his estimates.

Before delving into the numbers, Damodaran briefly explains some basic finance concepts for the uninformed. He explains that investors in the market demand a premium over the risk free rate of return to put their hard-earned money into stocks. The total return expected by the market from stocks is equal to the market risk premium plus the risk-free rate. In short, the return the market expects from stocks can be computed by looking at the level of the S&P 500 index and the expected cash flow from the index and asking: what discount rate would cause the expected future cash flows, once discounted to present value and aggregated, to equal the current level of the index? The discount rate necessary is the "expected return" on the S&P 500.

My Analysis Using Damodaran's Methodology

At the close of trading on November 15, 2012, the S&P 500 index was at 1353.33. Based on the expected cash flows projected by Damodaran in his spreadsheet, I calculated an expected return on stocks of 7.54% (implying an equity risk premium of 5.97% over the risk-free rate of 1.57% from the 10-year Treasury bond). In other words, the return the market is expecting from stocks on a pre-tax basis (based on the expected cash flows of the S&P 500) is 7.54%. Damodaran indicates in his spreadsheet that the annual dividend yield on the S&P 500 in September was about 2.09%. Thus, assuming that the dividend yield is the same today, the market is expecting stocks in the S&P 500 to appreciate in price by 5.45% (the difference between total expected return of 7.54% and the dividend yield of 2.09%, which is included in total expected return).

The after-tax return expected by the market at the current dividend and capital gains tax rates (both 15%) can be calculated using the following equation:

expected after-tax return = expected pre-tax price appreciation*(1 - capital gains tax rate) + expected dividend yield*(1 - dividend tax rate)

Using our numbers from above, the after-tax return expected by the market at current tax rates is 6.41% (5.45%*(1 - .15) + 2.09% *(1 - .15))

Assuming that the market will continue to demand the same after-tax return of 6.41% next year - in other words, that the market's risk preferences don't change - and that the dividend yield of 2.09% remains the same, we can calculate the expected pre-tax price appreciation of the S&P 500 index in the event the dividend tax rate is increased to 40% and the capital gains tax rate is increased to 20%. We simply use the equation from above and solve for the "expected pre-tax price appreciation" variable.

6.41% = Expected pre-tax price appreciation*(1 - .20) + 2.09%*(1 - .40).

Thus, given a 40% dividend tax rate and 20% capital gains tax rate, the S&P 500 index would have to appreciate 6.45% on a pre-tax basis (instead of 5.45% under current tax law) to come up with the after-tax return of 6.41% expected/demanded by the market under current risk preferences. The total pre-tax return expected/demanded by the market at the higher tax rates would be 8.54% (price appreciation of 6.45% + dividend yield of 2.09%). A total pre-tax expected return of 8.54% implies an equity risk premium of 6.97% over the risk-free rate of 1.57%. Using the 8.54% expected return as our discount rate and applying that to the cash flows we assumed on the S&P 500 index yields a present value of 1,155.97 for the index. This is 14.58% less than the 1353.33 level of the index on November 15, 2012, as I write this. Yikes! This means the S&P 500 SPDR (NYSEARCA:SPY) could go down to the $117 range from the current $135 - 136 level. Below is an interesting chart Damodaran created to demonstrate his findings.

Click to enlarge

Of course, these numbers are only as good as the assumptions made in the computation. Furthermore, some of the price decline is likely already priced into the market. The market has already declined 6.3% since the beginning of October. However, the consensus seems to be that a deal will be reached before January 1, 2013. But what if the consensus is wrong? In that case, perhaps much of the fiscal cliff's impact has yet to be priced into the market. Not to mention that the numbers above are based on a rational market reaction. If we do ultimately careen over the "fiscal cliff," irrationality could abound and we could see a drop far beyond rationality-the type of thing George Soros described in his Theory of Reflexivity. In any event, at least you can have fun playing around with Damodaran's spreadsheet.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.