Farrell: Watch Out—Here Come the Taxes

Somebody has to pay for the deficit.

And I'm not talking about just the "Obama" deficit but the years of excessive spending all of us have been guilty of. Even if this administration wanted to be serious about fiscal austerity, we would have a massive deficit. As it is, it looks like fiscal 2010's red ink will total over $1.5 trillion. I remember the late Senator from Illinois (of all places), Everett Dirksen, who once said "A billion here, a billion there, pretty soon you're talking about real money." He would freak at the thought of a trillion here or there.

The Obama budget calls for personal tax rates to revert to the levels before the Bush tax cuts. A top rate of 39% will yield $364 billion over the next ten years. Limiting deductions to 28% (this one strikes me as unfair when the top tax rate is 39%) will gross $291 billion. Limiting other deductions and raising the capital gains and dividend tax to 20% gets you $314 billion. It all adds up to some $969 billion over the decade. But that's if behavior doesn't change. And different tax rates always bring about some behavioral changes. These numbers are wrong, but only time will tell how wrong.

Corporate taxes will go up as well. $122 billion from taxing overseas income. $90 billion from the new tax on bank deposits, $60 billion from an accounting change on inventories and a bunch of other stuff that will all add up to about $380 billion over ten years. Even with the tax increases, we will add $8.5 trillion to the deficit, and that assumes all of it passes Congress and the ideas actually work the way they are hoped to. It won't all pass and it won't work the way it has been designed. The Wall Street Journal noted in Tuesday's paper that Senator Saxby Chandler (R-Ga.) has already weighed in with a fairly narrow view that the proposed budget "unfairly targets farmers and ranchers to achieve savings and fund Washington-based programs."

You have to give the White House some credit for using reasonable expectations.

They are planning for 3% GDP growth Q4 2010/Q4 2009, and 4.3% for the following year. 4.3% is aggressive, probably much too optimistic, but not outlandish. Their unemployment outlook is actually gloomy: 10% unemployment lasts through this year and falls to 9.2% in 2011 and 8.2% in 2012. I would be more optimistic than that.

The situation is stifling to such an extent you have to wonder if there is much any President could do. That makes President Obama irrelevant to some extent. He has very little wiggle room, and grand expectations have to be tempered. But if jobs are being created and the unemployment rate inches down come the midterm elections, the James Carville rule of "It's the economy, stupid" will prevail.

Between now and then a cautious investment approach might be the wisest.

Maury May of Soleil/Power Insights issued an update on Wisconsin Energy (WEC, Buy-rated, recent price $49.60). The company just reported Q4 results which were handily ahead of expectations at $0.96 a share compared to the consensus of $0.89. The full year was $3.20, well above the guidance the company had given at $3.05-$3.15, and up from last year's $3.03. WEC raised its dividend 18.5% about two weeks ago (to $1.60 a year) and Maury expects future dividend increases since they are winding down a long-term construction project of two new coal-fired plants. Because of the end of the construction and the utilization of the two new plants, Maury expects earnings of $3.70 for this year and $4.05 for next. His price target is $59. The $1.60 dividend provides a 3.2% current yield.

An even higher yield (4.1%) is offered by Kraft (KFT, Buy-rated, recent price $28.50). Eric Larson has initiated coverage with a $32 target. Kraft is closing on its acquisition of Cadbury today (Tuesday), and Eric thinks it is transformative. Cadbury should raise Kraft's long-term sales growth rate from 4%-plus to 5%-plus, and its earnings growth rate from 7-9% to more like 9-11%. Cadbury will represent about 21% of Kraft's total sales and the company could benefit from an improved product mix, better geographic distribution, and higher margins. The company should generate enormous free cash flow which could be used in part to pay down the debt incurred in the Cadbury acquisition (by probably in excess of $2 billion a year). The deleveraging, says Eric, could add two percent to Kraft's EPS growth rate beginning in the second half of calendar 2011.

The stock is now trading at a discount to the market and to the food group. Eric feels it deserves a slight premium to the food group as its earnings growth rate will be better. He targets a modest P/E of 13.8 times his preliminary 2011 estimate of $2.28, or $32.

Vincent Farrell, Jr. is chief investment officer at Soleil Securities Group and a regular contributor to CNBC.