Jerome Powell says it’s time to cut rates…is there a huge boom going on?…the prospect of a doubling of the capital gains tax…a tax on unrealized capital gains?

Welcome to the next cycle of rate cuts!

This morning, Federal Reserve Chairman Jerome Powell said at the Kansas City Federal Reserve’s annual conference in Jackson Hole, Wyoming, “The time has come to adjust policy.”

While he didn’t specifically mention “September,” the message was clear…

The interest rate cuts have been implemented.

Remember, the qualification for rate cuts was to get inflation back to 2% on a sustainable path. Well, here’s Powell: “My confidence has grown that inflation is back to 2% on a sustainable path.”

The question now is what happens after September. Will the Fed pause to review the economic data at its next meeting in late October/early November? Or should we expect quarter-point cuts at every Fed meeting through the end of the year?

On these questions, Powell returned to his traditional “let the data decide” position:

The direction of rate cuts is clear and the timing and pace of rate cuts will depend on incoming data, the changing outlook and the balance of risks.

Behind this policy shift is the Fed’s increasing focus on the weakening labor market

From Powell:

The unemployment rate began rising more than a year ago and is now at 4.3 percent. That’s still low by historical standards, but almost a full percentage point above where it was in early 2023. Most of that increase has occurred in the past six months…

…The cooling of labor market conditions is undeniable… We do not seek, nor do we welcome, any further cooling of labor market conditions.

Upside risks to inflation have diminished. And downside risks to employment have increased…

We will do everything we can to support a strong labor market as we make further progress towards price stability.

Welcome to rate cuts!

While the specific path and speed at which we move forward are unclear, “down” is the general direction for the near future.

As you might expect, the market is now celebrating given the news. And that raises a question…

Are we now going to see that huge supply of ‘sideline cash’ flood the market?

Perhaps. But even if it does, it may not result in the huge market surge that many investors are hoping for.

Just to make sure we’re all on the same page, we’ve been hearing for the past two years about a huge stash of “cash on the sidelines” that’s ready to be deployed in the U.S. stock market. The implication was, “If you think the market is doing well now, just wait until that cash on the sidelines starts rolling in.”

Here is MarketWatch already expressed this sentiment in March:

A record amount of money is sitting in U.S. money market funds. Some Wall Street pundits say the money is dry powder just waiting to be deployed in the stock market.

Now, this “record mountain of money” does exist, and if it comes to market, we should see an increase… but the size of that increase could be disappointing.

To unpack this, let’s go back in time…

Since October 2022, about $1.2 trillion has flowed into money market funds, pushing the face value of this “cash on the sidelines” to more than $6 trillion.

Yes, that is a record. And yes, it is a lot of money.

The problem is that focusing on this $6 trillion figure ignores an important context: the size of the entire stock market. When we put it into this context, this $6 trillion figure looks less like a mountain and more like a molehill.

We can see this in the graph below…

The white line is the size of this “money on the sidelines.” And as the headlines proclaim, it has continued to rise since 2022, now reaching over $6.2 trillion, a record high.

But the blue line shows this pile of money as a percentage of the value of the S&P 500. You’ll see that it’s near mid to low historical levels.

Source: Bloomberg

In the same way that a $100,000 down payment on a house would have been worth much more 10 years ago than it is today, $6 trillion in cash would have contributed much more to the S&P’s percentage gain 10 years ago than it does today.

Here’s commentary from analyst Kevin Gordon:

There may be a lot of “cash on the sidelines” in terms of total money market fund assets, but relative to the size of the stock market, the firepower simply isn’t what it used to be… and in fact, cash as a percentage of S&P 500 market cap has been on a downward trend over the past year.

Also note that the blue line has a rough “floor.” In other words, there is never a point where the entire supply of money floods the market. Some investors will always want to keep a portion of their assets in cash. And as you can see above with the blue line, the current level of the “cash-to-S&P” ratio is not that far above this floor level that dates back to 2007.

Here’s more color of it Morning Star:

The share of assets held in money market funds in long-term assets peaked at 63% at the height of the global financial crisis in 2008. Since 2011, the average has been around 20%.

At 23% of long-term assets at the end of January, US money market levels are not exceptional, even after the flood of inflows in 2023.

Source: Morningstar

Keep in mind that the chart above is from January. The market is up about 18% since then, meaning that the money on the sidelines is even less “out of the ordinary” today than it was then.

To put it plainly, a sustained, major meltdown in stocks could begin today. I hope so. But if it does, it will require help beyond deploying this $6 trillion cash hoard.

In a conversation about this with our editor-in-chief Luis Hernandez, Luis asked a good question: What happens in this light? Is money joining the rotation out of the Mag 7s stocks and flowing into small- and mid-caps?

I suspect Luis is right and we will see greater relative gains from small and mid caps, but this is a topic worth discussing. Digest.

If you are sitting on a load of investment gains, you may want to consider locking in some of the profits now.

This suggestion is based on Kamala Harris’s lead in the presidential election polls, combined with what we learned this week about her plans to tax investment gains.

To be clear, this is a proposal. And even if Harris wins the White House, the proposed tax changes will have to go through Congress. Right now, it looks like the House and Senate are Republican-leaning, according to the Cook Political Report.

So, this isn’t exactly set in stone. That said, let’s evaluate the proposal.

From Robert Frank on CNBC’s Squawkbox:

Vice President Harris is proposing to double the capital gains tax and tax unrealized capital gains for the very wealthy. Her campaign is backing a plan that calls for raising the top tax rate on long-term capital gains from 20% to 44.6%. That would be the highest rate in U.S. history.

Harris also advocates a tax on unrealized capital gains for the ultra-rich (net worth over $100 million). This would amount to a minimum tax of 25% on unrealized gains. So even if you don’t sell your business, you’re still obligated to pay Uncle Sam what he owes.

There is a workaround for private, illiquid companies. They would be taxed at their last valuation event, plus an annual increase. However, “illiquid taxpayers” (those with less than 20% of their wealth in marketable assets) would be able to defer payments until they die, but with interest charges at the time of payment.

While it’s tempting to dismiss this as “rich people’s problems,” let’s go back to our Digest from earlier this week about “second-level thinking.”

When you think about it on the first level, this tax plan seems like a great way to generate revenue for the government while making the wealthy “pay their fair share.”

Okay, but what about second-level thinking?

How does this tax plan change your incentive structure if you are extremely wealthy?

You want to avoid investing your wealth in public, tradable assets such as shares…

This increases the opportunity to sell these assets now (at a 20% profit rate) rather than when the policy takes effect (at a 44.6% tax rate)…

And you want to avoid a fair market valuation of your business, which could allow the IRS to levy taxes on unrealized gains…

This increases the attractiveness of making your company private.

In both cases, this increases the chance that money will disappear from the stock market.

Now consider that the top 1% of richest Americans own 54% of the public stock markets. If they are suddenly incentivized to sell stocks to protect their assets, that risks a significant decline in asset prices, not to mention a “new normal” in the future where there is simply less capital in the public markets.

That is not good for the stock portfolios of private investors.

But let’s continue with our second-level thinking…

Think of the venture capital world. Entrepreneurs will be less motivated to take their companies public. After all, the new incentive structure would reward maintaining a vague, private valuation.

But if you do go public, think about the impact on growth and R&D.

Now, it is unclear whether a corporation itself would be subject to the same tax on unrealized profits. Let us assume that this is the case, since current laws treat a corporation as a person.

If a business owner has to pay 25% tax on the unrealized appreciation in her business, that appreciation is only on paper – it is not cash in hand. Yet the tax bill is very real.

So that tax represents 25% less money that is now available to invest in growth opportunities, hire new employees, pay higher salaries/bonuses and/or invest in R&D.

It’s a huge drag on economic growth. And we haven’t even talked about Harris’ plan to raise corporate tax to 28%.

In short: Yes, the tax is targeted at the wealthiest Americans. But the idea that it wouldn’t trickle down and have negative financial consequences for millions of ordinary Americans (and their wallets) is shortsighted.

Now, to be objective, Trump’s tax plan would likely increase the risk of a resurgence of inflation. It would also worsen our national debt and deficit, because Trump’s tax plan would not raise the same amount of revenue. So he doesn’t get an “A” grade here either.

As we have explained before SummariesIt’s a bit of a “pick your poison” tradeoff. Whether it’s Uncle Sam or inflation, you’re going to get something for your money.

But let’s ignore that for now and welcome the new era of rate cuts.

Good evening,

Jeff Remsburg