Fat Valuations and Tech Stocks Seen as At Risk in Biden Tax Plan

(Bloomberg) -- Wall Street got its stimulus. Now it's hearing about the bill.

Aglow after trillions of dollars of government spending pushed markets to record after record in the first part of the year, securities professionals reacted cautiously to Joe Biden's proposal to raise taxes on investing profits. Many counseled calm, pointing to the likelihood of long negotiations, while also noting the plan had the potential to provoke pre-emptive selling, cut stock valuations and slow down the rally in tech shares.

Stocks buckled in the immediate aftermath of Bloomberg's report that Biden plans to nearly double the capital gains rate on the wealthy, with the S&P 500 falling as much as 1.2%. Still, the decline was minor next to the index's 85% return over the last 13 months, and most institutional investor said they'd wait to see how the bill progressed before doing anything rash.

"The devil will be in the details. Will it be retroactive to Jan. 1 of this year and then you wouldn't need to sell right away? Will it be the beginning of next year? That all begs the question, will it get passed?" said Chris Grisanti, chief equity strategist at MAI Capital Management. "There are a lot of moving parts. One thing investors can be sure of is that taxes are going up and we have to at least partially pay for all the money we've been spending on stimulus."

The Biden news shouldn't have been a surprise on Wall Street -- it's the same increase laid out in platforms released during the presidential campaign, and copious analysis had already been published prior to today. At Goldman Sachs, strategists led by David Kostin wrote as early as October that raising the rate would be a "minor speed bump for the upward trajectory of stock prices" that would shortly give way to fresh gains.

"History shows stock prices fall, equity allocations decline, and momentum underperforms ahead of increases in the capital gains tax rate," Goldman strategists wrote. "However, any potential equity selling will be short-lived and reversed in subsequent quarters."

Logically, Goldman says, stocks that have gained the most may get hit hardest in the short-term drawdown. That would include Tesla Inc. and its 400% gain in the past year, along with the Faang block of megacap tech shares that carried the market off the pandemic lows. In the S&P 500, Gap Inc., L Brands Inc. and Etsy Inc. are all sitting on gains of at least 200% in the last 12 months.

When capital gains were last raised under the Obama administration, in 2013, the wealthiest 1% "unsurprisingly" were the biggest stock sellers, Goldman said. Still, if investors were penalized by that hike, it didn't show in overall returns. The S&P 500 rose 30% that year, its best gain in almost a decade.

Goldman estimated in October that the top 1% holds around $1 trillion of unrealized capital gains. In 2013, that cohort sold "1% of equity their starting equity assets, which would equate to around $100 billion of selling in current terms," the strategists wrote. The group then turned around and bought the equivalent of 4% of holdings once the tax took effect in 2013, Goldman said, more than offsetting the selling.

The capital gains tax rate is a variable in a model tracked by Keith Parker, who's the head of U.S. equity strategy at UBS. Historically, when the tax rate changes, so does the multiple on the S&P 500, all else equal. The new proposal could mean a 7% hit to the PE multiple. That's because a higher rate could dull sentiment toward stocks, with investors less willing to pay up for earnings.

"Think of it as you're paying a price which is pre-tax and you get after-tax returns from either selling at a higher price or dividends, and the theory would just be that the price adjusts to compensate for that after-tax return," Parker said by phone. "For some investors, those future gains after tax would be notably less so the price adjusts."

Momentum stocks could feel the brunt of the impact, just as they did in 1986, when the tax rate on long-term capital gains rose to 28% from 20%. "So one other point to consider is, do stocks with large embedded capital gains start to price this in even more?," Parker said. "And we have seen some evidence of that playing out in the past."

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