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Four Ways the Fiscal Cliff Could Play Out


Your investor guide to the financial opportunity presented.

The constant news coverage of the fiscal cliff is becoming nauseating. So I thought I'd pile on, but cover it from a slightly different angle.

The media is focused on the impending recession from the budget cuts and tax increases. That is the main story. But what should an investor do about it? What should an investor expect to happen in the markets? That's the more important question. Let's see if we can rappel this cliff from that perspective.

First, if you need a primer on what cuts are coming and what tax changes are imminent with the cliff, check out this story at CNN Money. It's an excellent summary of the impending changes.

If we reach January 1 without a compromise, then the spending cuts and tax changes outlined in that story will go into effect. Even if they do take effect, more than likely a compromise will follow within one to two months, give or take a month.

So, with a compromise almost a certainty, you need to have a view on what will be included in it. I believe the compromise will include the following:

No. 1: Capital gains tax rates are going up, but dividend rates are not.

The fiscal cliff includes higher tax rates for everyone including the highest earners. Plus, long-term capital gains rates will go up 5%. Lastly, the qualified dividend tax rates are going to go up from the 15% rate today to whatever your regular income tax bracket is.

To me, the question is, what changes are implemented that causes the taxes to go up for the highest earners?

In the end, I think the dividend tax rate goes back to the lower levels. But the capital gains rate is likely to go to the 20% level from 15%.

The high-end tax rates is where the debate rages. The pundits think the Republicans have to give in here because the Democrats can bring the vote after January 1 to lower tax rates for the middle class alone – and would they dare not vote for it? Not voting for it is their only hammer in the debate on tax rates for the wealthiest earners.

I have more confidence that the dividend changes will be reversed and the capital gains rate will go up.

The Market Impact: There will be some selling pressure at the end of the year from people that have long-term capital gains and want to take those gains now at the lower rates. But that pressure will be short-lived. It will be more like a ripple than a wave. Why? Because those investors need to re-deploy those funds back into the market so they need to be buyers again – more than likely of another stock.

The likely losers: stocks with large gains over the last 12+ months. The entire market has had a nice run the last year so many companies fit this description. The Apples (NASDAQ:AAPL) of the world probably have the most to lose (and are already seeing some of that pressure).

But these investors will need to come back in to the market – and after 30 days could even come right back in to the stock they sold.

Don't believe the hype that a large sell-off will have legs because of the capital gains changes.
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No positions in stocks mentioned.
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