By: Douglas J Utberg

As this post is being published, the Dow Jones Industrial Average has closed below 10,000 placing an exclamation point on what many people fear to be a foreboding of future economic sluggishness or even the dreaded ‘double dip recession’.  Throughout 2010, the stock market has been abnormally volatile, with no clear up or down trend.  This phenomenon demonstrates the extent to which the financial marketplace is uncertain about both future economic prospects and the actions that the government and federal reserve may (or may not) take to help (or harm) the economy.

Dow Jones market value trend from WSJ

In addition to all of these market concerns over economic fundamentals, there is an additional specter facing investors.  Unless congress acts in the remaining sessions before the end of 2010, federal taxes on long-term capital gains will increase from 15% to 20% in 2011.  It is important to note that this is not a “5% increase in capital gains taxes” as some on the left attempt to characterize the initiative . . . it is a 33% increase in taxes on capital gains.  (5% tax increase divided by a 15% current tax rate = 33% increase)

Unless action is taken to address this problem soon, there is likely to be a large amount of investors who sell their stocks and mutual funds to lock-in their gains at the current favorable tax rates.  As this unfolds, it may push the stock market into a temporary downward spiral where people taking gains push down the value, which compels more people to capture gains before the value goes down even more.  When this phenomenon combines with the generally unpredictable nature of government action, it could create the conditions for a second recessionary dip.

Action Item: Consider diversifying some of your stock market assets into cash so that you have capital available for strategic buying opportunities that emerge if an investor sell-off to lock in profits at favorable tax rates pushes the stock market value below a level that reasonably represents its underlying fundamentals.