The Biggest Myth About Taxes And The Fiscal Cliff

by: Lou Basenese

Another week's gone by and there's still no resolution on the Fiscal Cliff. The only thing that's changed, really, is investors' fear. As BMO Capital Markets' Brian Belski, says, "A resolution to the so-called 'Fiscal Cliff' is anyone's guess at the moment, but what is clear based on our client conversations is that the prospect of higher taxes has clearly spooked investors."

If we want hard, non-anecdotal evidence, look no further than the recent performance of dividend stocks. Instead of flocking to the safety of this corner of the market, investors are fleeing from it. As Bespoke Investment Group notes, "Instead of outperforming as the market has declined [since Election Day]… dividend payers in the S&P 500 have underperformed."

The conclusion? "This clearly shows that investors are making a strategic shift out of dividend payers due to the looming tax increase on dividend income," said Bespoke.

That's a huge mistake. Again, bailing on dividend stocks - or all stocks, for that matter - simply because of the threat of higher taxes makes no sense. Even if most pundits might be telling you otherwise. And today, in honor of Myth-Busting Monday, I'm going to prove it.

Higher Taxes, Higher Stock Prices

Longtime readers know I've already dedicated considerable ink to debunking the myth that a dividend tax rate increase would be disastrous. You can re-read my work here, here and here. Or, if you prefer, I can sum it up for you with a single line from my previous commentary: "Fears over a dividend tax rate hike are completely overblown."

I'm going to go one step further today and say that fears over any tax hike are completely overblown, especially concerning the impact on the stock market. And here's the evidence to back me up, courtesy of Minyanville's James Debevec.

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As you can see, stocks actually perform best when dividend tax rates are the highest. I know. It's totally counterintuitive. But the facts don't lie.

If you're stubborn and just aren't ready to relinquish your fears over a tax hike leading to a bear market, here's another dose of truth serum, this time courtesy of BMO… "According to our work, average market returns are quite strong in years immediately following tax hikes," says Belski.

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Given the average rise of 17.8% over the first year, I'd say the returns are "quite strong," indeed.

Note that the returns following tax cuts are "well below historical norms," as Belski says. So does that mean we should favor higher and higher taxes? Not just "no." But "hell no!"

As Belski explains, "This [underperformance] is because the economy happened to be weaker in those years, not because of tax policy."

Bottom line: I'm the last person to advocate higher taxes. I subscribe to John Maynard Keynes' school of thought that "the avoidance of taxes is the only intellectual pursuit that still carries any reward."

When it comes to higher taxes as a result of the Fiscal Cliff, though, they appear unavoidable. But in this situation, in the famous words of FDR, "The only thing we have to fear is fear itself." Because contrary to conventional wisdom, tax hikes will not derail the stock market.

And once again, we've busted another Wall Street myth. All in a day's work!