EXPERIENCE MAGAZINE 
 

You Figure It Out!

By: Richard M. Colombik, JD, CPA 

As I write this version of an investment report I have just finished reviewing four economists viewpoints and, just like four experienced attorneys they all have logical yet different conclusions.  The Dow Jones Industrial Average on May 28, 2003 closed at a tad under 8800 the NASDAQ Composite at 1563 and the S & P 500 at 953.  Year to date the Dow Jones Industrial is up at a whopping 2.16% whereas the NASDAQ is up 12.88%, a respectable gain.  Yet, for the last year the Dow is cumulatively down 11.91% and the NASDAQ is down 5.38%.   

Last week?s tax cut has apparently been good news for the market, but I, for one, particularly being a tax attorney don?t quite understand why.  Historically, when stocks go up bonds go down.  They generally travel in inverse ranges.  Yet, many days, we are actually seeing stocks and bonds both rising.  Stocks rose for a fifth consecutive day, sending the NASDAQ to a one-year high and the S & P 500 to a nine-month peak.  The Dow is at levels it hasn?t seen since mid-January.   Further, key executives of Microsoft and Dell are selling shares in record amounts.  Why the confusion?   

Let us take a look at the technical issues in today?s environment.  On a valuation basis, remember value stocks were the big buzzwords the last few years, the large cap indexes appear to many market forecasters to appear expensive.  For example, the large caps of the Standard and Poor?s Industrials are trading for about 25 times earnings.   This type of valuation level does not normally occur at market bottoms.  This may mean that even at current depressed levels, the market is still overvalued.   Yet the market has been reaching 2003 new highs. 

Unemployment claims are high.  Additionally they continue to rise.  There doesn?t seem to be any fundamental reasons for the market rallying.  Yet, many economists see the economy as improving and believe the Federal Open Market Committee is likely to ease short-term interest rates.  The federal fund rates are so low at this point, a four-decade low.  How much lower can they go?  Many money market funds may be put out of business if the funds rate gets reduced even lower, as their real rate of return minus expenses would not allow them to keep a one dollar per share value.  Remember what I said about unemployment?  Initial claims are above 400,000 for fourteen consecutive weeks, capacity utilization is at a twenty-year low, if the economy is growing it most assuredly is not robust growth.   

Many corporate profits are occurring by laying people off, reducing office space and cutting costs.  They are not being achieved by real growth of many entities.   

Enough of the technical analysis, what about the tax cuts?  The true benefit for the market, particularly for the short-range appears to be in high dividend yielding stocks.  As we have previously reported in other columns the strategy of buying dividend-yielding stocks, combined with selling covered calls will receive the largest benefit from this tax act.  What has occurred is a reduction in the rate of taxation on dividends as well capital gains.  Therefore, a dividend yield, presuming you qualify for the fine print and are in a top tax bracket would be taxed at 15%, the federal taxation bond yield would be taxed on the top tax bracket of 35%.   What does this mean for you?   

                  Dividend  Interest

Investment  $10,000 $10,000

Yield 5% 5%

Annual income $500 $500

Federal tax $75 $175

Yield $425 $325 

Based upon the foregoing, it would appear that a comparable dividend yield has a dramatic effect for people in the top tax bracket.   

Further, let?s add to this scenario utilization that we discussed in our last column of writing covered call options.  If we presume a covered call option on the stock of Exxon, the stock is currently selling for 37 per share and the option premium for a January 2004, $35 call option is 3.70.   The dividend yield is 2.677%.   Let?s take a look at our charts 

                  Dividend  Interest

Investment  $10,000 $10,000

Yield 2.67% 5%

Annual income $267 $500

Federal tax $40 $175

Net $237 $325

Effective Yield 2.37% 3.25%

Option Premium

(Net of share loss of $2) 170

Income Tax  -60

Net Yield Option  110

Net Yield Option 6 months  

(Annualize)   110   

Net Yield Dividend 237

Total Return $457 $325 

This shows that based upon the new tax, if one is to take a strategy of buying a well diversified portfolio of moderate dividend paying stocks, writing covered calls they can not only protect some downside risks, but also obtain an income stream that has favorable income tax rates.  One should not abandon bonds but must diversify by taking into effect the tax income tax and covered call writing.  (Note:  Exxon was not used as a method of recommending its stock just an example of a large company with a gross dividend barely 53% of the bond example noted above).   

Tax wise, other strategies are to look into mutual funds that have that have large accumulated capital losses that they have not yet distributed.  Buying into such a mutual fund would allow you to receive distributions that do not have any taxation relative to their capital gains.   Their gains would net against their losses.  There are Internet sites that track the mutual fund status so that you can also look at this strategy as well.   

The new tax act will favor stocks over bonds.  By selling covered calls and diversifying your portfolio you can help protect against some downside risk.  The key is to keep a diversified income producing portfolio and keep repeating the call writing strategy.   

Retirement style investing still requires one to diversify their portfolio and maintain a balance.  Therefore, one may wish to consider adding bonds into their retirement accounts since they are not currently taxed, whereas having a heavier concentration of dividend paying stocks in their non-retirement accounts, where income tax is due.  Remember, that income taxation is an important of one?s net yield.  It isn?t the gross number on top; it is how much of that number remains in your pocket that counts.   

I can?t give you predictions on where the market will go, but I can tell you that tax legislation and income taxes affect the market every single year.  With the new tax act, dividend-paying stocks will become more popular than ever.