So far, June has delivered two serious headwinds for the US stock market.  Both come from the taxman.

Here’s how.  This bull market in the United States has been driven, in large part, by a net retirement (shrinkage) of outstanding shares.  The shrinkage is due to stock buybacks by public companies and by private equity deals that retire shares held by the public. 

From June 30, 2004 through March 31, 2007 net US stock retirement (shrinkage) totaled $993 billion.  This is the all time record.  It was achieved in a very short period.  In the latest calendar quarter (March 31, 2007) stock buybacks in the S&P 500 reached an unprecedented 3.6% of market cap (rolling 4 qtr total).

Buybacks and private equity deals have both been spurred by special tax treatment.  That is now over.  We will explain below after a brief comment on interest rates. 

We must first note that the shrinkage was encouraged by low interest rates which provided cheap financing.  The borrowed money was used to buy into a half century high US profit share.  That provided substantial investment returns.   Recent higher interest rates work against this favorable structure by dampening the cheap financing.  But this commentary is not about the rise in interest rates.  That is/was bad enough for stocks.  Today we want to focus on the end of the shrinkage.

History shows that markets have always performed better during shrinkage periods and poorer during high net new issuance periods.  I cannot find any strategic exception to this rule.

There’s a reason why net retirement (shrinkage) or net issuance is critical to stock market performance.  It is the simple rule of supply and demand.  When the inventory of outstanding shares is growing, stocks have trouble rising in price.  The net new issuance helps meet the financial demand for investment in the stock market asset class so prices rise slowly or not at all.  When company buybacks and private equity deals retire stocks, the supply shrinks and prices tend to rise more vigorously.  Demand is met with fewer shares. 

Headwind number 1.

Until last week, stock buybacks were considered routine.  Not much attention had been paid to the source of the funds.  Then IBM announced a $12.5 billion stock buyback.  That changed everything.  The Internal Revenue Service (IRS) realized that IBM was using money from its foreign subsidiaries to fund the buybacks.  This money has not been taxed by the US.  Normally foreign subsidiary income does not get taxed by the IRS until it is repatriated.  IBM estimated they were saving $1.6 billion by using this method. 

The IRS moved quickly and by surprise.  IBM announced its plan on May 29th.  The IRS publicized the regulatory change on May 31st.  IBM is the last large American company to get under the wire. 

There is nothing new about funding buybacks from lower taxed foreign funds.  What’s new is that the IRS has stopped it.  The IBM deal will proceed with favorable tax treatment.  Henceforth any buyback funded from a foreign source will be taxed as repatriation.  This is very serious.  At 35%, US corporate income taxes are among the highest in the world.   Ireland, for example has a 12.5% rate.  So why would a company like Pfizer or Intel seek to incur a high tax bill by moving money from its Irish subsidiary under this new rule.  The answer is simple -- they won’t.

You might ask why this rule has existed for a while and not been changed earlier in this business cycle.  The answer is another special tax effect.  In 2004, the Congress and Bush Administration allowed a one-time repatriation for all US companies.  Instead of taxing them at 35% the special deal reduced the tax to about 5%.  This expired at the end of 2005.  Over $300 billion moved back to the US under that special tax deal.  Much of it has been used to fund buybacks.

Headwind number 2.

The news about a proposed IRS code change for Blackstone is the second bad item.  There is a part of a private equity and/or hedge fund transaction called “carried interest”.  Until now, it has been taxed at capital gain rates of 15%.  That tax occurs when the private equity partnership does an IPO as Blackstone plans.  The US Senate proposed legislation that changes that tax rate to 35%.  This not only impacts every private equity and hedge fund valuation but it may also apply to other forms of partnerships.  Real estate folks should pay close attention to this change.

In Blackstone’s case it will cause a revaluation of the IPO unless some exception is granted in the new law.  Even with the exception, there are likely to be court cases involving any favoritism for Blackstone.  For the rest of the multi-billion private equity partnership and the hedge fund operators, this is a severe blow. 

Private equity deals are measured by the net present value of the exit strategy.  Tax rates are a huge part of that calculation.  Hence, this tax change is big and it reduces the present value of any future transaction.

Markets are affected even if this never becomes law.  The reason is that there is no way to know if it will pass and therefore any new private equity deal may be subject to the new tax structure.  Our system exposes taxpayers to taxation once the law is introduced.   If it is passed in the future, the date of introduction can govern the start of the tax impact and not the date of passage.

This is not the first time.

History shows that we have had events like this before.  In the late 1980s high yield (junk) bonds were used to fund leveraged buyouts (LBO).  Michael Milken was the junk bond king of that era.  Then, the key was deductibility of the interest.  Legislation was introduced to remove the tax deduction.  That ended the LBO era even though the proposed law never passed.  Just the threat of it was enough to kill the LBO structure of that time. 

Stocks had good performance during the LBO era.  From March 31, 1984 through December 31, 1990 the net shrinkage was $562 billion.  Markets rose robustly and even overcame the 1987 crash.  Once the legal changed was introduced, LBOs effectively stopped and markets struggled.  Net shrinkage morphed into net new issuance.  From March 31, 1991 to June 30, 1994, net new issuance was $184 billion and market performance was tepid.

The grand bull market from the mid-1990s through the top of the NASDAQ bubble saw another round of shrinkage.  Nearly $700 billion of stock was retired.  When stocks subsequently collapsed with the bubble implosion, markets languished.  2002 through March 31, 2004 was a period of net new issuance. 

A strategy change at Cumberland.

We think these two tax changes may dramatically reduce shrinkage.  One is now law (IRS did it by regulation) and the other is proposed and may pass.  The Congress seems disposed to do it. 

We do not know if they will result in a swing to net new issuance.  We do know that two of the reasons for recent US stock market performance have been removed in the last two weeks.   Cumberland has instituted a cash reserve in our domestic US accounts.  We only use exchange-traded funds and we continue to favor the large cap companies over the small caps.  Our largest over weight position is in the tech sector.

Our bond accounts remain defensively postured.  That has helped protect them from the rise in interest rates.  We are readying accounts to lengthen duration but have not yet done so.  It is too soon to buy long term bonds.

Within the constraints of time and television programming we will try to discuss some of these issues while guest hosting CNBC’s Squawk Box from 7 to 9 tomorrow (Monday) morning.    

Some end notes are in order.  Market data is from Ned Davis Research.  Special thanks to Howard Simons of Bianco Research and Jason Trennert of Strategas for some details about these changes.  Also thanks to Wall St. Journal’s William Bulkeley (WSJ, June 7th) and Michael Lewitt of HCM.  And to my colleagues Matt Forester and Bill Witherell for research assistance.