How a Simple Change in Tax Policy Can Help Remove Speculation from the Markets
After the whole GameStop and Robinhood saga, you started seeing articles with titles like When Investors Forget Fundamentals, the Market Is Broken. And Congresspeople saying that a group of people has been using the stock market like “a casino for decades.”
If you don’t closely follow the stock market, this probably confirmed many beliefs. It is a precarious place where rich people get richer and poor people either don’t play or get scammed when they try.
This kind of sentiment around the stock market is not new, but it has gotten a fresh breath of life after GameStop’s events.
Many people are voicing their opinion about what happened and venting their frustration with Wall Street, but if you read my pieces, you know that’s not me. I have thoughts, but I want them to be quickly followed with explanations and solutions. In this article, I discuss why speculative companies, like GameStop, have become so enticing for many investors and offer one potential tax solution that could incentivize more fundamental-based investing.
How We Got Here
The stock market is designed to be just like any market. You have buyers, and you have sellers. And based on the supply and demand of the good, the price changes. It is pretty straightforward. But how did this market become so rife with speculation?
Unlike other markets, when you buy stocks, you are not getting a good or service, but instead, you are getting ownership in a company. Depending on the company, this ownership can mean a lot of different things. For some, it means you get a vote on company initiatives; for some, you get direct access to a percentage of the company’s profits through dividends; and for others, you get nothing except a piece of paper that says you own a share.
It is the last scenario that I believe has brought rampant speculation to the stock market. When all you receive through ownership is a piece of paper, people quickly begin speculating on the paper’s value.
What Are Market Fundamentals?
In the introduction, I referenced an article that said when people forget about fundamentals, the market is broken. I am sure some people are wondering — What are fundamentals?
In their most basic terms, fundamentals are specifications. When you buy a computer, you look at processing speed, battery life, and storage, but not so much how many calories are in it.
You don’t care about a computer’s calorie count because you are not buying the laptop to eat it. So, the calorie count isn’t a worthwhile specification to consider. While some people read this as an “out-there” example, similar behavior is happening in the stock market.
The two main reasons people invest is:
- Make Money (Short-Term)
- Send a Message (Make Money Long-Term)
When you buy a company to make money in the short-term, you look very closely at profits, revenue, and costs. You are looking at these because strong numbers there make it likely a company can continue to grow (most likely leading to an increased stock price) or, better yet pay you some of that extra profit in the way of a dividend.
When you buy shares in a company to send a message — think Beyond Meat (BYND) — you are buying more because you believe more in their mission and less in making money in the short-term.
Sending a message can be very profitable. For example, I could see Beyond Meat eventually being very profitable. But when your time horizon gets extended to 5-to-10 years, there is a lot of guesswork in how you justify the price you are willing to pay today. We barely know what the weather will be in 5 days, let alone what will happen to the demand for faux meat products.
What is the Issue?
I think there is room for both types of investors in the market. Short-Term focused and Long-Term focused. I think that is healthy. The problem is you have a lot of short-term focused investors putting money into these long-term plays trying to make a fast buck because that is the only way to do it due to current tax policy.
An investor who is solely interested in making money from their stock ownership used to invest in companies that paid out dividends. They would look for companies with consistent and growing profits and buy them to get a sizable check a couple of times a year from the company.
Quick tax lesson:
- Short-Term Capital Gains: When you own a stock for less than a year and sell it for a profit, it is taxed as income taxed at your marginal tax rate. Looking north of 24%
- Long-Term Capital Gains: When you own a stock for over a year and sell it for a profit, you are only taxed 15%. This incentivizes people to buy and hold instead of buying and quickly selling.
- Dividend Income: It is taxed just like income, so you are paying a marginal tax rate. Generally speaking north of 24%.
If an investor will have to pay the same to Uncle Sam (US government) regardless of whether they receive dividends from a stable profit-generating company or make a quick trade on a hyper-growth company like Tesla (TSLA). Where companies do you expect people to gravitate to?
If you guessed highly speculative companies, you are right. People can win in the short-term (day trading) and the long-term (better tax rate) if they decide to buy and hold and the stock goes up. This is what is happening in companies like Tesla, Beyond Meat, Tilray, the list goes on and on.
What is My Solution?
I would change the way dividends are taxed. At a minimum, I would say have them taxed at a 15% rate, maybe even lower. This would incentivize people who are just trying to make a fast buck to look at companies with solid fundamentals and good track records of success, instead of just highly speculative ones.
I would also increase the time frame for long-term capital gains to more than one year. I am not sure precisely what the adequate time would be, but the less volatile a company’s stock, the easier it is for them to use their shares to raise capital to fuel growth, leading to either lower unemployment or wage growth.
If more investors are shopping for dividends and are tied into their stock picks for longer to receive a lower tax rate. I think investors will begin to value consistency and honesty over hype and momentum.
Thank you for reading this piece. I know there were many dense topics covered here, but I think it will make you a much more informed participant in the next conversation where GameStop or the stock market comes up.
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