The Bush proposal may have given the market the warm fuzzies Monday. Let's throw cold water on that. January 8, 2003: 1:11 PM EST
By Justin Lahart, CNN/Money Staff Writer
NEW YORK (CNN/Money) - Reports that White House will propose an end to the tax on investor dividends cast a warm, green glow on the market Monday.
"People like the plan," said Jim Volk, director of institutional trading at D.A. Davidson. "It doesn't mean that the Dow's going straight to 9,000, but this could be relatively helpful for the market."
The Dow Jones industrial average finished Monday up 171 points to 8,773 and the S&P 500 was up 2.2 percent. Leading the way were stocks with the highest dividend yields, like El Paso, Goodyear Tire and FleetBoston.
But while the elimination of dividend taxes would undoubtedly be good for the market -- because it increases investors' returns, it means that stocks can, at least theoretically, carry higher valuations -- many Wall Streeters cautioned that it's no panacea.
"Yes, it's an unambiguous positive," said J.P. Morgan strategist Carlos Asilis. "But in terms of its overall importance, it's only marginal."
Giving it back These stocks have the highest dividend yields in the S&P 500.
Company
Dividend yield*
El Paso
11.2%
RJ Reynolds
9.1%
Teco Energy
8.6%
American Electric Power
8.3%
Centerpoint Energy
7.5%
Goodyear Tire
7.1%
CMS Energy
7%
Xcel Energy
6.5%
Public Service Enterprises
6.4%
Philip Morris
6.5%
* As of Jan. 03. Not including REITs.
Source: Baseline
Part of the problem, says Asilis, is that the dividend yield on the overall market right now is so low -- just 1.7 percent for the S&P 500. With such a marginal payout, the elimination of the dividend tax doesn't give investors that much more back, overall. If the market's dividend yield was much higher, Asilis thinks that it would be a much bigger positive.
Nor does Asilis think that the elimination of the dividend tax will prompt many companies to up their dividend payouts, at least as things stand now. Companies are simply too indebted, their balance sheets too fragile. The debt-to-equity level on the S&P is more than 25 percent higher now than it was in 1994 -- companies need to use their cash to pay off that debt, not pay off their shareholders.
Bush dividend savings
If Stock 'x' pays $5 a year per share in dividends and you pay $100 for the stock, you're getting a 5% yield. But those dividends are taxed at income tax rates -- if President Bush's proposal to eliminate the dividend tax goes through, those payments will be much more valuable. Use this calculator to estimate the gains for a stock holding.
Current after-tax dividends:
Dividends without taxes:
GAIN:
Of course it is the shareholders, ultimately, who control the company. With an elimination of the dividend tax, won't there be a great hue and cry from them for higher dividends?
Don't count on it, said Brett Gallagher, head of U.S. equities at Julius Baer. As it stands now, pension, 401(k) and IRA plans aren't taxed on dividends. And mutual fund managers' performances aren't judged on after-tax returns, so they have no new incentive to agitate for bigger dividend payouts. Individual investors might want to see more dividends, but institutions -- which for the most part want their investments to appreciate, rather than provide a steady income -- don't seem to. And institutions control most of America's shares outstanding.
"Eliminating the dividend tax is a psychological positive for the market," said Gallagher, "but at the end of the day, it's no big deal."
Gallagher reckons that it matters on an individual stock level, however. His fund holds positions in a number of preferred shares -- a special class of stock that pays a dividend at a specific rate -- with the view that they would become more appealing to individual investors if the dividend tax was cut.
Gallagher thinks that some of the cash-rich tech companies might start to give some dollars back to shareholders. Even that might be a stretch, unfortunately.
Consider Cisco, which opposed a proposal (shot down 10-to-1 by shareholders in November) that it start paying dividends. The spin on this one was that the taxation issue was the big reason for Cisco not to give out a dividend.
Look at the proxy statement it sent out to shareholders ahead of the vote, though, and you'll see it was hardly the only one: Cisco trumpeted the way it's used its cash for buying back shares, plunking it down on research and development and growing operations, concluding that it "continues to have great opportunities to build and expand its business." It sounds like Cisco management would rather keep its cash to play with rather than pay it out in a dividend.
"It's a great deal for individual investors, but I don't know what kind of incentive the elimination of the tax is going to give to some of the cash cows to start offering dividends," said Merrill Lynch strategist Kari Pinkernell.