Stocks closely modestly lower on proposal to raise capital gains tax rate

Income earned by the sweat of your brow should be taxed at the lowest rates, not the highest. Capital gains should be taxed at a higher rate. – John Bogle

Both the S&P 500 Index and the Dow Jones Industrial Average had their four-week winning streaks snapped last week as both benchmarks closed modestly lower despite continued strong quarterly earnings and mostly favorable economic data. The Nasdaq Composite Index also edged slightly lower but still managed to close above 14,000. The major stock averages probably would have kept their winning streak intact had it not been for a news leak that the Biden administration plans to raise the capital gains tax rate to 39.6% for those individuals earning $1 million or more, up from the current rate of 20%. While it has been known for quite some time that this administration wants to raise taxes, the news on Thursday caught investors by surprise and the stock market tumbled. Fortunately, stocks recovered most of their losses on Friday as the preliminary Purchasing Managers’ Indexes (PMI) for manufacturing and services in April were better than expected. Earnings season also has been a positive one so far as 85% of the companies that have reported have beaten analysts’ estimates. Most of these same companies have trounced expectations by more than 20% on average. However, there were some red flags that surfaced last week. Many S&P 500 companies that beat bottom-line earnings estimates saw their stock prices drop, suggesting that much of the good news on the corporate earnings side is already priced into the market. More important has been the forward guidance by companies for future earnings, which have tended to be conservative due to the uncertain path of Covid-19. Just last week, the World Health Organization (WHO) warned that global coronavirus infections were approaching their highest level in the pandemic. Even though 3 million vaccinations are being administered per day in the U.S., over 67,000 daily new infections are still being recorded.

Last Week

U.S. leading economic indicators in March were much better than expected, suggesting that economic momentum is increasing over the near term. New home sales in March surged to a 15-year high and were higher than forecast, a sharp contrast to the huge decline in February due to severe winter storms across many parts of the country. Although existing home sales fell in March and registered the slowest sales pace since August, the drop was due to the limited supply of homes for sale as demand remains very strong. Weekly jobless claims totaled 547,000, below estimates of 603,000 and a sign that the labor market is getting stronger.

For the week, the Dow Jones Industrial Average dropped 0.5% to close at 34,043 while the S&P 500 Index declined 0.1% to close at 4,180. The Nasdaq Composite Index fell 0.3% to close at 14,016.

This Week

The advance estimate for first quarter gross domestic product (GDP) is forecast to show an annual growth rate of 5.6%, compared to 4.3% in the fourth quarter of 2020. Durable goods orders in March are expected to increase modestly after declining last month while the ISM Chicago Purchasing Manager’s Index (PMI) for April is forecast to be slightly lower than in March but above 60, comfortably in expansion territory. Both the Consumer Confidence Index and the University of Michigan consumer sentiment index for April are forecast to be higher than in March as consumers become more optimistic about the economy as it reopens.

The Federal Open Market Committee (FOMC) will meet to review its monetary policy and is widely expected to leave the federal funds rate near zero, despite an anticipated surge in economic growth this year and a recent rise in bond yields over the last few months.

This will be the busiest week of the earnings season and the most prominent companies scheduled to report  their earnings are Tesla, 3M, Raytheon Technologies, UPS, Boeing, Ford Motor, General Dynamics,  Caterpillar, Advanced Micro Devices, Alphabet (Google), Microsoft, Texas Instruments, Apple, Facebook, Qualcomm, Amazon, Amgen, Eli Lilly, Bristol Myers Squibb, Starbucks, McDonald’s, Kraft Heinz, Visa, Mastercard, Chevron and Exxon Mobil.

Portfolio Strategy

One of the worst performing sectors of the market last year was real estate investment trusts or REITs as the coronavirus pandemic took its toll on office buildings and shopping malls. The Vanguard REIT ETF (VNQ), which invests in companies that buy office buildings, hotels, shopping malls, apartment buildings, storage facilities, nursing homes, health care facilities and other real property, was down 5% in 2020 while the S&P 500 Index gained 18%. But the gradual reopening of the economy with more people being vaccinated every day has propelled the Vanguard REIT ETF to a year-to-date gain of 15.75%, beating the S&P 500 Index total return of 11.8%. It has been one of the top performing sectors this year and might still have some upside as REITs are currently cheaper than the overall market. As long as people continue to get vaccinated, the number of infections continues to decline and people begin to return to the office and shop at the malls, REITs should do well as they remain relatively cheap by historical standards. Another benefit of REITs is their above-average yield as the Vanguard REIT ETF currently has a distribution yield of 3.5%. REITs also tend to outperform other sectors when inflation rises above 2%, a likely scenario given the huge amount of fiscal and monetary stimulus that has been put in place to jump-start the economy. REITs are normally a defensive sector, too, and help diversify a portfolio as they tend to behave differently than either stocks or bonds.