CAPITAL GAIN=MARKET PAIN?

By Daniel Kadlec

Hooray, the long-term capital-gains tax rate has been cut. That's good news--if you know how to use it. The last two times the rate fell, in 1978 and 1981, some distinct patterns emerged: the stock market sank but ultimately staged a powerful recovery. There was also a noticeable flow into the stocks of small companies. The problem is that in this so-called new-era economy, historical benchmarks have been about as useful as an abacus in Silicon Valley. To borrow a phrase from the new-era crowd, it's different this time.

The tax bill that President Clinton signed into law last week lowers the rate on long-term capital gains from 28% to 20%. The gains-rate cut in 1978 was from 35% to 28%, and in 1981, from 28% to 20%. The '81 cut was rolled back in '86. After the '78 tax act, the Standard & Poor's 500 dropped 11% in six weeks as investors sold stocks in order to record gains that would be taxed at the new low rate. In '81, the S&P 500 plunged 15% in six weeks. Later the markets took off as investors sought low-tax opportunities. The '78 sell-off paved the way for a two-year runup that enabled the S&P 500 to snap out of a 14-year funk. The '81 sell-off set the stage for the mother of all bull markets in 1982.

Clearly, the Clinton Administration expects a repeat of sorts. It projects $1.2 billion of tax revenue this year and $6.3 billion next year from the sale of stock and other assets triggered by the lower rate. Somebody should explain the new era to Washington: nobody is a net seller of stocks anymore. Since the tax act cleared Congress on July 28, the market has held up fine. We aren't interested in some piddling tax consideration while stocks are rising 30% a year. Some selling may materialize this week as the deadline passes for a line-item veto. But so far the response to this tax cut has been nothing like the previous two.

O.K. So there's no immediate pattern of selling. Shouldn't the lower rate pave the way for another bull stampede by encouraging more investment? Not necessarily. Unlike the previous two reductions, this one comes amid a sizzling love affair with the market. There is no need to rekindle our passion for stocks; we're hopelessly obsessed. "This market needed a stimulus like Einstein needed a higher education," notes Tom McManus, strategist at NatWest Securities.

Another departure from the past has to do with the stocks of small companies. They typically do not pay a dividend--the payoff is in price appreciation. That makes them more desirable when the cap-gains rate falls because dividends get taxed as ordinary income--a higher rate for most investors. Yet big stocks have been rising fastest all year, and that could persist. Why? Big stocks, as defined by the S&P 500, now have a measly 1.6% dividend yield, vs. 6% in the early '80s. In short, they're also being managed for growth instead of income. Of course, the market reacts to many things in the economy, not just tax changes. So nothing is certain, except that the old tools just don't work the way they used to.

Daniel Kadlec is TIME's Wall Street columnist. Reach him at kadlec@time.com