The fiscal cliff means major tax increases and spending cuts are due beginning in 2013 unless Congress reaches a budget deal. What is the average investor to do?
First of all, don't lose sleep over it. Congress will almost certainly reach a deal to minimize any effects of a fiscal cliff. Even if no deal is reached, a fiscal cliff is unlikely to have much effect on the financial markets. We have lived under much higher taxes in the past for decades; the current top rate of 15 percent tax on dividend income is extremely low compared to as high as 90 percent in the past. Additionally, the stock market is forward looking and probably has already priced in much of the effects of a fiscal cliff.
That being said, higher taxes are almost certainly coming. Investors are well served to position for higher taxes on dividends and capital gains in the near future.
Get out of bonds. Bond interest is taxed as ordinary income, which will likely get taxed as high as 39.5 percent starting 2013, as the president and Congress push for higher taxes. Also, with bond yields so low right now, even lower than stock dividend yields, but without offering the growth potential as stocks do, bonds are almost certainly a losing bet. If you must buy bonds for short term needs (i.e. less than 3-5 years), stick with short term individual bonds and hold them till maturity. Avoid bond funds such as BND, AGG, BLV like the plague. Please see my article Why Bonds Are No Longer Sound Investments for more details on why long term bonds are a disaster waiting to happen.
Reduce positions in high flyer or overvalued stocks. If you have held a position in a stock for at least a year, and the market price of the stock has significantly increased from your cost basis to the point of becoming overvalued, now is a good time to take some profits off the table before the end of the year. You will lock in profits at a maximum of 15 percent long term capital gains tax, before the tax goes up, and downside risk is avoided, as overvalued stocks tend to be the first to drop in a market correction. Apple (AAPL), which has had a big run up in price from a year ago, has already embarked on a correction recently. See my article 5 Reasons Apple Is A Bad Bet for more details on why investors should not chase performance, especially on a hot tech stock. FB, GRPN, AMZN, are other prime candidates for reduction.
Shy away from high dividend stocks. REITs, like AGNC and NLY with dividend yields in the double digits, respectively, come to mind. REITs should only be held in tax sheltered accounts such as IRA, and not in taxable accounts, because their dividends are taxed at the much higher rate as ordinary income. Other sectors to avoid for now are utility and telecom stocks: they have been bid up too high recently by yield hungry investors and they tend to have high dividend yields, high payout ratios, and low or no growth.
Avoid low quality stocks. Low quality stocks, like AA and GM, are likely to require much more frequent trading. Significantly higher taxes on short term capital gains will eat away much of the returns, if any. The historic annual stock market return is approximately 10%. If the long term capital gains tax goes up from 15% to 20% next year, your expected after tax return is only 8%. After selling a stock position that cost your $1000 for $1100 after a year, you would only have $1080 to reinvest after paying the 20% long term gains tax. To obtain the 10% average market return, you would need to reinvest in another stock that can deliver at least 12%, or 20% above market return. This can be quite a hurdle to overcome.
Accumulate low dividend, high quality stocks. Look for companies with dividend yields less than 4%, payout ratio less than 50%, have consistent growing earnings and dividends for many years, preferably decades, and high return on equity with little debt. CR Bard (BCR), a dividend aristocrat, is a good example. It has a dividend yield of 0.83%; its payout ratio is currently only 13%, and has never exceeded 30% for the past decade. CR Bard has increased its dividend for 40 consecutive years; its earnings growth for the past 10 years is 13.8%. The demand for medical devices will likely continue to grow at a robust pace with the aging population. See my articles Less Is More: Why I Prefer Low Yield Stocks for more details.
Consider no dividend, high quality stocks. No dividend can be even better than low dividend, if dividend tax goes up by a lot, and you can find the type of no dividend stocks that can also provide consistently satisfactory growth and returns. Not too many stocks will meet these stipulations, but Berkshire Hathaway (BRK.A) comes to mind. Although the company pays no dividends, it has reinvested its earnings into successful businesses and handily outperformed the market for decades. While even Buffett acknowledged that future returns for his company will not be as great as in the past, and he has recently decided to buy back shares of the company at up to 120% of book value, the returns should continue to be satisfactory for the foreseeable future. If the qualified dividend tax rate of 15% expires and dividends gets taxed as ordinary income, which can be as high as 39.5%, then quality growth stocks that pay no dividends deserves serious consideration. I would consider 39.5% to be a very high hurdle to overcome.
Have a long term investment horizon. As discussed above, when taxes increase, they can seriously eat into your returns. Select quality stocks carefully that you can hold them for at least 5-10 years, buy them when they become out of favor, and hold them for at least 5 years. To beat the fiscal cliff and the coming higher taxes, hold onto your stocks and let your gains compound tax free for years and decades. I will conclude by quoting Buffett:
If you don't feel comfortable owning something for 10 years, then don't own it for 10 minutes.