Taxes Vs. Spending Cuts: No Fiscal Cliff Solution Without Pain

by: ChartProphet

[I discussed the Fiscal Cliff and my stock picks on BNN on November 27th - Click here to watch video]

Following the U.S. elections, investor focus has shifted to the fiscal cliff. With $600B+ in automatic tax hikes and spending cuts, the fiscal cliff is a huge threat to economic stability and consumer confidence. According to some honorable economics and analysts, if a viable solution is not agreed on the U.S. could actually enter recession. Even more shocking: There is only one month left to solve problems we've debated for years!

So what are our options? How can we save ourselves from the massive turmoil that would emerge if we don't do something now? Why can't politicians come to an agreement? And where should you invest your money with a lot of upside but without major risk?

In short, there is no quick and easy solution. The fiscal cliff is the escalation of a long-standing and very heated debate over taxes and excess government spending. After decades of arguing, over ten years of volatile markets and recessions which have only exacerbated the situation, and an increasingly deteriorating global economy, what makes people think we're going to solve our problems so easily in one month?

The Problem

Low taxes and high government spending are simply unsustainable. One thing we have to accept is that the economy cannot continue to thrive, or even survive, if it grows artificially. For the past decade, and especially since the 2007-2008 recession, the economy and the stock market have been boosted and supported by government stimulus and historically-low interest rates. In order to avoid a very deep recession or even depression, the U.S. government together with the Federal Reserve tried to accelerate the economic recovery and "climb its way out" of the mess. To do so, it used its tools of low taxes, extremely low borrowing rates, and record-setting government spending.

But you can't just escape recession. Recessions are sometimes necessary to "clean up the excesses" of the preceding growth period. In other words, times of growth and speculation also come with unsustainable growth and over-speculation that must be fixed before the next phase of growth can continue; the economy must build a firm foundation before it can proceed. But since the Dot-Com bubble burst in 2000-2001, and again when the housing bubble popped in 2006-2008, the government has been interfering with the market forces and preventing them from naturally fixing the problem. Instead of accepting the inevitable recession and preparing for our next growth phase, the government and Federal Reserve have attempted to escape the necessary deleveraging process and heal a sick market without actually fixing the root cause.

Attempting to avoid a deep recession is understandable, but the government's strategies have reached a breaking point - with such a huge deficit and constant economic uncertainty, critical decisions must be made. After a decade of low taxes and enormous government spending aimed at stimulating consumer spending and supporting the economic recovery, we can't continue on this path. The government must figure out how to reduce the deficit and increase its revenues to pay off its enormous debt. Low taxes and high spending, as they currently stand, simply cannot persist.

The Debate: Taxes vs. Spending

There are two major sides to this debate of how to solve the fiscal cliff issue. Is the solution to continue to give most consumers a pass on taxes while increasing taxes on the wealthy? Or is the solution to follow an effective deficit reduction plan through spending cuts?

Obama and many Democrats favor increasing taxes for the wealthy, while continuing tax breaks for those earning under $250k. This would help increase government revenues, but why should the wealthy have to pay more? And furthermore, even with higher taxes for the wealthy, that doesn't solve most of our major issues when it comes to economic stability and exorbitant government spending.

Republicans, on the other hand, generally don't want increased taxes. Instead of imposing "unfair" and unequal treatment when it comes to taxes, many Republicans and others believe that we need to fix the mess and reduce our deficit by stopping the insane amount of spending by government. The problem is that we don't know exactly where to cut spending - we could hurt the military, education, government entitlement programs, social security. Even worse, we're not yet sure if austerity and spending cuts can be implemented without negatively shocking the economic system. The Federal Reserve and Obama Administration have attempted to pump our way out of recession - and the strategy may work - so implementing big spending cuts could completely derail our recovery. At the same time, spending is a big issue.

The Solutions

We probably need both. We need more fiscal responsibility together with less spending, but we also should accept the possibility of higher taxes. The U.S. has seen some of the lowest tax rates for a long time now, and they're probably only going up from here. That said, it's not necessarily fair to only increase taxes on the wealthy; and moreover, what exactly is "wealthy"? Obama thinks it's $250k and up, but others say $500k or $1M. Regardless, we may need higher taxes, but how can we expect the wealthy to accept these higher taxes if they don't see that the government is actually improving its own behavior and being more cautious and smarter about how it spends?

What we really need is increased revenues with reduced spending. Both sides, Democrats and Republicans, need to compromise while at the same time winning. To help the Democrats, taxes should be increased on the wealthy while spending is not completely shut down. To appease the Republicans, however, taxes would also have to be raised for everyone else (we can't just single the wealthy out). Furthermore, spending really needs to come under control - Obama, the Federal Reserve, and politicians need to figure out what spending is most important and what can be reduced. Only taxing the rich will not cut our deficit by enough and will definitely not solve our core issues; at the same time, cutting spending without dealing with the tax debate will not be enough to increase revenues, and could even shock the system.

With only one month left, it's hard to see how politicians can come to a compromise and form a long-lasting plan. This has been a heated debate, and one to which nobody really knows the right answer. The possibilities include: (1) kicking the can down the road (short-term solution), (2) solving the problem (miraculous long-term solution), or (3) shocking the system by failing to compromise (threatens U.S. economic stability and financial safety).

With the fiscal cliff debacle and a global economic slowdown among other major hurdles, it pays to be on the very cautious side. Apple (NASDAQ:AAPL) has likely reached an all-time peak and is leading the market down, Oil (NYSEARCA:OIL) is still trading below $100 (and even $90) due to weakened demand and slowing global growth, Europe is in recession, China is still hurting, and the stock market as a whole is only a few percentage points below major overhead resistance at our previous highs in September. We're cautious and more bearish on the overall market (NYSEARCA:SPY), and gold (NYSEARCA:GLD) won't save you, but there are always some good buying opportunities.

What We Like

We're cautious on the high-flyers, but we like three companies trading at great valuations, involved in markets or sectors with huge upside opportunities, and priced right near objective support levels that limit our risk in case we're wrong.

Devon Energy (NYSE:DVN) - We're very bullish on the natural gas (NYSEARCA:UNG) theme and think it's "The Buy of the Decade" (See: Natural Gas: The Buy Of The Decade). Natural gas itself is up 100 percent from its summer lows, but some natural gas producers are even down since then. Devon is one of those companies giving investors an amazing opportunity to profit from natural gas. With a $20B market cap, a forward PE of 12, and diversification both in location and in product (nat gas, nat gas liquids, and oil), DVN is a great value. It also pays a 1.5% dividend. Most importantly, it's trading at $53 with support at $50. If the market drops as a whole, or DVN drops by itself, you know where to get out with less than 6 percent at risk.

Activision (NASDAQ:ATVI) - Activision has become the gaming powerhouse. It now controls much of the console gaming market with major hits like World of Warcraft and Call of Duty (with a recently released version). It will also be the major player in the growing zombie theme, with The Walking Dead game coming out in 2013 (See: Investing In Zombies). At a $12.6B market cap, $3.36B in cash ($3/share), no debt, a 1.6% dividend, and near a strong $10-$10.50 support level, ATVI looks like a great outperformer here if the market rises. If the market falls or the investment choice turns out to be wrong, you simply get out if it drops and holds below the $10 support.

Silicon Image (NASDAQ:SIMG) - At only a $400M market cap, SIMG is a speculative but potentially very rewarding company. With a number of very promising products and technologies aimed at huge growing markets, including its MHL chip which is inside the top-selling Samsung Galaxy III and 4 of 5 of the top smartphone makers in the world (See: Silicon Image: The Number 1 Way To Profit From The Apple Vs. Samsung Battle), Silicon Image could be a great way to profit from huge opportunities in the smartphone, TV, gaming, computer, and wireless streaming space. With $150M in cash (30%+ of market cap) and no debt, the company looks well positioned for growth. We'll see if they can pull it off and become a billion dollar company, but trading near $4 support this could be a great buying opportunity at low risk.

Disclosure: I am long SIMG, DVN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. May initiate long position in ATVI, short position in GLD

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